Income Tax AY 2026-27: Taxation Of Leave Encashment Under Section 10(10AA) Explained

Salaried employees are entitled to various types of paid leave each year, including sick leave, casual leave and earned or annual leave. However, not all employees utilize their entire leave balance. In such cases, they may either carry forward the unused leaves to the next year, subject to company policy, or opt for leave encashment and receive monetary compensation for the unused leave days.

While leave encashment can provide an additional financial benefit, it may also be subject to income tax. The tax treatment depends on when the amount is received and whether the employee works in the government or private sector. Employees may also be eligible for tax exemptions on leave encashment, subject to specified conditions and limits under the Income Tax Act.

What Is Leave Encashment?

Leave encashment refers to the monetary compensation received by an employee in exchange for unutilized paid leave accumulated during the course of employment.

Taxation Of Leave Encashment Under Section 10(10AA)

The taxability of leave encashment depends on the timing of receipt. It can be received either during employment or at the time of retirement, resignation or termination.

Leave Encashment During Employment

If an employee opts to encash unused leave while still in service, the amount received is fully taxable as salary income. However, the employee may be eligible for tax relief under Section 89 of the Income Tax Act, which helps reduce the tax burden arising from receiving such income in a lump sum. To claim this relief, the employee must submit Form 10E through the Income Tax Department's e-filing portal before filing the Income Tax Return (ITR).

Leave Encashment On Retirement Or Resignation

Employees may also receive leave encashment at the time of retirement or resignation. The tax treatment varies depending on the nature of employment.

Government Employees

Employees retiring from Central or State Government service are entitled to a full tax exemption on the leave encashment amount received at retirement.

Legal Heirs Of A Deceased Employee

If an employee passes away before receiving leave encashment, the amount paid to their legal heirs is fully exempt from income tax.

Private Sector And Non-Government Employees

Private-sector and non-government employees can claim an exemption on leave encashment received at retirement or resignation under Section 10(10AA). The maximum exemption available is Rs 25 lakh. Any amount received in excess of this limit is taxable as salary income. The exempt amount is calculated in accordance with the provisions of Section 10(10AA) of the Income-tax Act.

How To Report Leave Encashment In Income Tax Return?

Leave encashment received at the time of retirement or resignation should be reported under the head "Income from Salary" in Schedule S of the Income Tax Return (ITR). Meanwhile, the exempt portion eligible under Section 10(10AA) should be separately disclosed under Exempt Income ("Allowances to the extent exempt under Section 10"). The remaining amount, if any, should be included as taxable salary income. Most importantly, taxpayers should ensure that the leave encashment details reported in the ITR match the figures mentioned in Form 16.