Leave encashment meaning
In India, leave encashment refers to the process of converting accumulated and unused paid leave days into monetary compensation. When an employee does not utilize their entitled leave days, they have the option to encash or convert those unused leave days into cash, which is paid out by their employer.
Leave encashment is typically granted upon certain conditions, such as retirement, resignation, or the termination of employment. The payment for leave encashment is calculated based on the employee's salary and the number of accumulated and unutilized leave days.
Leave encashment formula and its calculation
The calculation of leave encashment for private employees in India can vary depending on the company's policies and practices.
The leave encashment formula is
Leave encashment amount = Daily wage rate x Number of unutilized leave days
However, let us see an example calculation based on a common approach used by some organizations.
Let's consider the following scenario:
Basic Salary: ₹50,000 per month
Total accumulated leave days: 30 days
Company policy: Leave encashment is calculated at a daily wage rate based on basic salary.
Step 1: Determine the daily wage rate
Daily wage rate = (Basic Salary / Total working days in a month)
Assuming there are 30 working days in a month:
Daily wage rate = (₹50,000 / 30) = ₹1,666.67
Step 2: Calculate leave encashment amount
Leave encashment amount = (Daily wage rate x Number of unutilized leave days)
In this example, if the employee has 30 unutilized leave days:
Leave encashment amount = (₹1,666.67 x 30) = ₹50,000
So, in this case, the leave encashment amount for the employee would be ₹50,000.
Leave encashment rules
Capping on leave encashment
Companies have the right to put a cap on the maximum number of paid leaves that will be encashed per employee per year.
Notice period and unused paid leaves
If an employee has unused paid leaves accumulated, they can adjust it against their notice period. However, it is at the discretion of the company. Employees and HR managers along with the reporting manager can negotiate this.
Read: Buy out notice period
Leave carry forward policy
When an employees doesn’t use all the earned leaves, they can carry forward the unused leaves to the next year. Companies can design leave carry forward policy themselves and put a cap on how many leaves can be carried forward.
- This policy comes helpful to employees if are planning for a vacation or wedding next year and want to use all the saved up leaves.
- Can be used if the company has a leave encashment policy at retirement.
Unlimited leave policy
In the context of leave encashment with an unlimited leave policy, the concept of leave encashment may work differently compared to traditional leave policies. Since there is no specific limit on the number of leave days, there may not be a provision for leave encashment based on unused leave days.
Tax on leave encashment
It's important to note that the tax treatment and exemptions for leave encashment in India vary based on factors such as the type of employee (government or non-government), the reason for encashment (retirement or during employment), and the specific provisions of the Income Tax Act.
Also check: Tax-saving options for salaried employees
Read more about it in the below section.
Leave encashment tax exemption
For private company employees, leave encashment received at the time of retirement is partially exempt under Section 10(10AA) of the Income Tax Act, subject to certain limits and conditions.
Leave encashment received during the course of employment is fully taxable.
Leave encashment tax exemption calculation
To calculate tax exemption for leave encashment for any non-government employees, consider four key components:
- Actual leave encashment received
- 10 months' average salary
- Cash equivalent of unutilized earned leave (limited to 30 days per year of service)
- Fixed exemption limit of ₹3,00,000.
The least value among the above key components is exempted from tax.
Points to remember!!!
- If your actual leave encashment is below ₹3,00,000, then it's fully exempt. If it's above ₹3,00,000, compare it with the other components to find the least exempted amount.
- Calculate the average salary for the 10 months preceding the month of leave encashment. Compare it with ₹3,00,000 and the other components to find the least exempted amount.
- Find the cash equivalent using the prescribed limit (30 days per year of service). Multiply your daily wage rate by the unutilized leave days, ensuring it doesn't exceed the maximum limit. Compare it with ₹3,00,000 and the other components.
For instance, let's say the actual leave encashment received is ₹2,50,000, the 10 months' average salary is ₹3,20,000, and the cash equivalent of unutilized earned leave is ₹2,80,000. In this case, ₹2,50,000 would be tax-exempt as it is the least of the components.
Understanding these steps will help you navigate the tax implications of leave encashment, ensuring you optimize tax benefits while complying with regulations. If needed, consult with tax professionals for personalized advice based on your specific financial scenario.