Leave encashment is a valuable benefit where your employer pays you for the vacation days you earned but did not use during your career. For many, this results in a significant lump sum payment at the time of retirement or resignation, acting as a financial cushion for the next chapter of life. However, the tax department views this money as a form of salary, and Section 10(10AA) was created to provide much-needed tax relief. By offering specific exemptions, the law ensures that you can keep more of your hard-earned savings provided you understand the different rules that apply to government officials versus those working in the private sector.

The Basics: When is it Taxable?

The timing of when you receive your leave encashment determines how much tax you will pay.

During Service: If you choose to sell your leaves while you are still working for the company, the entire amount is fully taxable. It is added to your salary income and taxed at your regular slab rate.
At Retirement or Resignation: This is when Section 10(10AA) kicks in to offer exemptions.
On Death: If leave encashment is paid to the legal heirs of a deceased employee, the entire amount is 100% tax-free.

The Big Change: New Exemption Limits (2025-26)

For years, the maximum tax-free limit for private-sector employees was stuck at a low ₹3 lakh. Following recent budget updates that remain in effect for the 2025-26 assessment year, this has been massively increased to provide better relief for the middle class.

Employee Category

Tax Treatment (At Retirement/Resignation)

Government Employees (Central/State)

Fully Exempt (No limit)

Private Sector Employees

Exempt up to ₹25 Lakh (Subject to rules)

Public Sector/Bank Employees

Treated as Non-Government (₹25 Lakh limit applies)

How to Calculate the Exemption for Private Employees

If you work in a private company, your tax-free amount is the lowest of these four values:

Actual Amount Received: The total leave encashment your employer pays you.
Statutory Limit: The maximum cap of ₹25,00,000.
10 Months' Average Salary: Your average basic salary + DA for the 10 months immediately before retirement.
Cash Equivalent of Unused Leaves: Calculated based on a maximum of 30 days of leave for every year of service.

Calculation Example

Imagine you retire after 20 years with an average monthly salary of ₹1,00,000. You have 300 days of unused leave and receive ₹10,00,000.

10 months' salary = ₹10,00,000.
Actual received = ₹10,00,000.
Statutory limit = ₹25,00,000.
Result: In this case, the entire ₹10 Lakh is exempt because it is lower than the ₹25 Lakh cap.

Important Rules to Remember

30-Day Cap: Even if your company allows 45 days of leave per year, the tax department only recognizes 30 days per year for calculating your exemption.
Lifetime Limit: The ₹25 lakh limit is a lifetime cap. If you claimed ₹5 lakh exemption in a previous job, you only have ₹20 lakh left for your future retirements.
Average Salary Components: For this section, Salary strictly means Basic Pay + Dearness Allowance (DA) + Turnover-based commission. HRA and other allowances are excluded.

Exemption in New vs. Old Tax Regime

A common question for 2025-26 is whether this benefit exists in the New Tax Regime.

Both Regimes: The Section 10(10AA) exemption is available under both the Old and the New Tax Regimes.
Section 89 Relief: If you encash leaves while in service and face a high tax burden, you can claim relief under Section 89, though this is primarily beneficial in the Old Regime.

Conclusion

Section 10(10AA) is a vital tool for ensuring your retirement corpus stays intact. With the limit now raised to ₹25 lakh, most private-sector employees will find their entire leave encashment becomes tax-free. The key is to check your company's leave policy specifically how many days are encashable and ensure your HR department calculates the TDS correctly based on these latest 2025-26 limits. By planning your leave usage toward the end of your career, you can maximize this one-time tax benefit and secure a better financial future.

Frequently Asked Questions (FAQs)

Is leave encashment fully tax-free for all employees?

No. It is fully tax-free only for Central and State Government employees at the time of retirement. Private employees have a ₹25 lakh limit.

What if I resign instead of retiring?

The exemption rules for resignation are the same as retirement under Section 10(10AA) for both government and private employees.

Does this exemption apply if I encash leaves every year?

No. Any leave encashment received during service is fully taxable. The exemption only applies when you leave the job.

I work for a Nationalized Bank. Am I a government employee?

For this section, bank employees are generally considered non-government employees, meaning the ₹25 lakh limit applies to them.

Can I claim this exemption more than once?

Yes, but the total amount you claim across your entire career cannot exceed the ₹25 lakh lifetime limit.

What happens to the money if it's paid to my family after my death?

Leave encashment paid to the legal heirs of a deceased employee is 100% exempt from tax, regardless of the amount.

Is the ₹25 lakh limit applicable for the 2025-26 financial year?

Yes, the increased limit of ₹25 lakh (up from ₹3 lakh) is fully applicable for the current period.

Do I need to submit any documents to claim this?

Your employer will usually calculate the exempt portion and show it in your Form 16. You just need to report it correctly in your ITR.

Can I encash Sick Leaves or Casual Leaves?

Most companies only allow the encashment of Earned Leaves (Privilege Leaves). Casual and sick leaves usually lapse at the end of the year.

How is the average salary calculated?

It is the average of your basic pay and DA for the 10 months immediately preceding your retirement or resignation.

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