How much leave encashment is tax-free? For non-government employees, leave encashment received at retirement or resignation is exempt up to Rs. 25 lakh under Section 10(10AA) (CBDT Notification 31/2023, effective April 1, 2023). The exempt amount is the lowest of: the actual leave encashment received, 10 months' average salary, cash equivalent of earned leave at 30 days per completed year of service, and Rs. 25 lakh. Government employees receive full exemption with no cap.
When Is Leave Encashment Taxable?
Your company's leave policy probably lets you accumulate earned leave and cash it out. The tax treatment depends entirely on when you receive that payment.
During service: If your employer pays you for unused leave while you're still employed, every rupee of it is salary income under Section 17(1). No exemption. No deduction. It goes straight into your taxable salary, and your employer deducts TDS on it under Section 192.
At retirement or resignation: This is where Section 10(10AA) kicks in. When you receive leave encashment at the time of leaving your job, whether that's superannuation, resignation, or voluntary retirement, part or all of the amount can be exempt from tax.
The distinction matters more than people realise. Say you cash out 15 days of leave in December while still working, and then resign in March and cash out another 45 days. The December payment is fully taxable. Only the March payment qualifies for the Section 10(10AA) exemption.
How the Rs. 25 Lakh Exemption Works (Four Limits)
For non-government employees, the exempt amount is not automatically Rs. 25 lakh. It's the lowest of these four figures:
1. Actual leave encashment received: The amount your employer actually pays you for unutilised earned leave at the time of retirement or resignation.
2. 10 months' average salary: Your average monthly salary (Basic + DA + turnover-based commission only) for the 10 months immediately before retirement, multiplied by 10. HRA, special allowances, and bonuses don't count.
3. Cash equivalent of unutilised leave: Here's the catch. Even if your company credits 45 or 60 days of leave per year, the tax law caps the calculation at 30 days per completed year of service. The formula: (Daily salary) x (Earned leave balance, capped at 30 days per year of service minus leave already availed).
4. Rs. 25 lakh: The statutory ceiling set by CBDT Notification 31/2023, effective from April 1, 2023. Before this notification, the limit was just Rs. 3 lakh (unchanged since 2002).
The exemption equals whichever of these four amounts is the smallest. Everything above that is taxable salary.
Worked Example
Ravi resigns from a private company after 12 years of service in June 2026. His leave encashment details:
- Basic salary: Rs. 80,000/month, DA: Rs. 10,000/month (total salary for this purpose: Rs. 90,000/month)
- Total earned leave balance: 420 days (company credits 35 days/year)
- Leave encashment received: Rs. 12,60,000
Here's how each limit works:
Limit A (Actual amount): Rs. 12,60,000
Limit B (10 months' average salary): Rs. 90,000 x 10 = Rs. 9,00,000
Limit C (Cash equivalent of leave): The tax law caps recognised leave at 30 days per year. For 12 completed years, that's 360 days maximum. Ravi's 420-day balance gets capped to 360 days. Daily salary: Rs. 90,000 ÷ 30 = Rs. 3,000. Cash equivalent: 360 x Rs. 3,000 = Rs. 10,80,000.
Limit D (Statutory cap): Rs. 25,00,000 (no prior claims).
Exemption = lowest = Rs. 9,00,000 (Limit B).
Taxable leave encashment: Rs. 12,60,000 minus Rs. 9,00,000 = Rs. 3,60,000. This Rs. 3,60,000 gets added to Ravi's salary income and taxed at his applicable slab rate.
Notice how Limit B (10 months' salary) was the binding constraint, not the Rs. 25 lakh cap. For most employees earning moderate salaries, Limit B or Limit C will typically be the lowest.
How to Report Leave Encashment in Your ITR
Leave encashment goes into Schedule S (Salary) of your ITR form (ITR 1, ITR 2, or ITR 3). Here's how:
Step 1: Your employer includes the full leave encashment in your gross salary in Form 16 (Part B).
Step 2: The exempt portion under Section 10(10AA) appears in the "Allowances exempt under Section 10" section of Form 16.
Step 3: In your ITR, report the full salary (including leave encashment) under Schedule S. Then claim the exempt amount separately under "Allowances to the extent exempt under Section 10" by selecting "Section 10(10AA) - Earned leave encashment on retirement" from the dropdown.
Step 4: Cross-verify that the exempt amount in your ITR matches what your employer has shown in Form 16. If your employer didn't compute the exemption (some don't), calculate it yourself using the four-limit formula and claim it in your ITR.
For employees who changed jobs and received leave encashment from multiple employers, the Rs. 25 lakh lifetime cap applies across all of them. Reduce the limit by any exemption claimed in earlier years.
What About the Income Tax Act 2025?
The Income Tax Act 2025 replaced the 1961 Act with effect from April 1, 2026. However, the ITR forms for AY 2026-27 (FY 2025-26) continue to reference Section 10(10AA) from the 1961 Act since the income pertains to a period before the new Act took effect. The substantive rule and the Rs. 25 lakh exemption limit remain unchanged. For AY 2027-28 onwards, check the corresponding section in the 2025 Act.
Common Mistakes to Avoid
Claiming exemption on leave encashment during service: This is the most frequent error. If you cashed out leave while still employed and claimed Section 10(10AA) exemption on it, expect a notice. The exemption applies only at retirement or resignation.
Ignoring the 30-day cap: Your company may credit 45 or 60 days of earned leave per year. The tax department doesn't care. For exemption purposes, only 30 days per completed year of service counts. Using your company's leave balance instead of the capped figure overstates the exemption.
Forgetting the lifetime cap: If you claimed Rs. 8 lakh exemption from a previous employer and now claim Rs. 25 lakh from your current employer, you'll get a notice. The maximum across your entire career is Rs. 25 lakh total.
Tax Garden Handles Your Leave Encashment ITR
If you've received leave encashment this year, whether at resignation or retirement, getting the exemption calculation right is critical. Overclaim it and you'll get a notice. Underclaim it and you pay tax you didn't owe. Tax Garden files your four-limit exemption, checks your lifetime cap, files Form 10E for Section 89(1) relief if applicable, and reports the correct figures in your ITR.
