Leave encashment taxability in 2026 — during service, on resignation and on retirement, section 10(10AA) exemption up to ₹25 lakh and aggregate limits across employers.
Leave encashment is the cash paid by an employer in lieu of unused earned leave. It is one of the few salary components in Indian tax law where the treatment changes sharply based on the timing — during service, on resignation, on retirement, and the nature of the employer. For FY 2026-27 the exemption ceiling for non-government employees under section 10(10AA)(ii) continues at ₹25 lakh, a number meaningfully higher than the earlier ₹3 lakh limit notified before its revision.
Three Situations and Three Tax Outcomes
- Leave encashed during continuation of service — fully taxable as salary in the year of receipt
- Leave encashed on resignation — taxable as salary, with no special exemption under section 10(10AA)
- Leave encashment on retirement or superannuation — exempt up to the specified limit under section 10(10AA), balance taxable
Section 10(10AA) — The Retirement Exemption
For a government employee, leave encashment received on retirement is fully exempt under section 10(10AA)(i). For a non-government employee, exemption is the least of four amounts — the actual leave encashment received, ₹25 lakh as notified, ten months of average salary, and cash equivalent of leave to the credit at the time of retirement subject to a maximum of thirty days of average salary for each completed year of service.
How Average Salary Is Computed
Average salary means the average of the salary drawn during the ten months immediately preceding the retirement. Salary for this purpose includes basic salary and dearness allowance forming part of retirement benefits, plus any fixed percentage commission on turnover. It does not include perquisites, HRA, transport allowance or any other allowance that is not part of retirement benefits.
Aggregate Cap Across Employers
- The ₹25 lakh ceiling is a lifetime cap across all employers
- If you have claimed exemption with a previous employer, the unused portion alone is available with the current employer
- Employees changing jobs must therefore track every prior exemption claim and disclose it to the next employer
- Failure to disclose results in over-claim, which the department recovers with interest at assessment
Treatment Under the New Tax Regime
Section 10(10AA) exemption continues to be available even if the employee opts for the new tax regime under section 115BAC. This is a notable carve-out, because many other exemptions and chapter VI-A deductions are switched off in the new regime. Retirement-related receipts such as gratuity under section 10(10), commuted pension under section 10(10A) and leave encashment under section 10(10AA) remain protected.
Conclusion
Leave encashment is a significant lump-sum that can move a retiree's tax bill in either direction depending on planning. Use the higher exemption ceiling effectively, distinguish carefully between resignation and retirement payouts, track aggregate exemption across employers, and report leave encashment correctly in the ITR. Done well, the ₹25 lakh ceiling can deliver meaningful tax saving on what is often a once-in-a-career receipt.
