Retiring in 2026? Check how much tax-free leave encashment you can claim before filing ITR

Leave encashment allows employees to receive money for unused earned leave. However, the tax treatment depends on when the payment is received. If leave encashment is received while still employed, it is generally fully taxable as salary. Tax benefits are available when it is received at the time of retirement or separation from service.

Yes. Leave encashment that is received while you are still employed is usually treated as salary income and taxed accordingly. This rule applies to both government and non-government employees. The special tax exemptions available under the Income Tax Act generally apply only when leave encashment is paid upon retirement, resignation, or termination of employment.

Central and state government employees enjoy the most favourable tax treatment. Leave encashment received at the time of retirement is fully exempt from income tax under Section 10(10AA)(i) of the Income Tax Act. This means the entire amount received as leave encashment can be claimed as tax-free income upon retirement.

For private-sector and PSU employees, leave encashment received on retirement is exempt only up to specified limits. Any amount exceeding the eligible exemption becomes taxable. The exemption is available under Section 10(10AA)(ii) and is calculated using prescribed conditions related to salary, earned leave balance, and the amount actually received.

The exemption available to non-government employees is the lowest of four amounts: leave salary received, 10 months' average salary, the notified limit of Rs 25 lakh, or the value of eligible earned leave. The calculation can be complex, making it important for retirees to verify the figures before filing their tax returns.

For leave encashment exemption purposes, salary is not limited to basic pay. It includes the average salary of the last 10 months, comprising basic salary, dearness allowance, and commission based on a fixed percentage of turnover achieved by the employee. These components directly affect the amount of exemption available.

The government increased the tax exemption limit for non-government employees from Rs 3 lakh to Rs 25 lakh through a CBDT notification issued in 2023. This significantly enhanced the tax benefit available to private-sector employees and PSU staff receiving leave encashment at the time of retirement.

Leave encashment received on retirement should be reported under the 'Income from Salary' section in the income tax return. The exempt portion eligible under Section 10(10AA) should be disclosed separately as exempt income, while any remaining amount must be reported as taxable salary. Taxpayers should also ensure consistency with Form 16 details.