TDS on Leave Encashment: How Section 10(10AA) Decides What Is Tax-Free and What Is Taxed
TL;DR
- Leave encashment received during continuing service is fully taxable as salary, and your employer deducts TDS under Section 192.
- At the time of retirement or resignation, Section 10(10AA) provides an exemption — government employees are fully exempt, private employees up to Rs. 25 lakh.
- The Rs. 25 lakh limit was raised from Rs. 3 lakh in 2023 through CBDT Notification 31/2023.
- This Rs. 25 lakh limit is a lifetime cumulative cap across all employers, not a per-employer or per-event cap.
- Employers must apply this exemption while computing TDS on the final settlement and reflect it in Form 16 Part B.
What this means in plain terms
Leave encashment is one of those salary components people only think about when they are about to retire or resign. The rules around it have a quiet but big effect on the lump sum that hits your account. The tax treatment depends entirely on two questions — is this happening during service or at separation, and are you a government employee or a private sector employee.
If you sell unused leave back to your employer while still working, the entire amount is added to your salary and taxed. There is no special exemption. But if you are retiring, resigning, or leaving service for any reason, Section 10(10AA) kicks in. Government employees walk away with the entire leave encashment tax-free. Private sector employees get an exemption up to Rs. 25 lakh, computed using a specific formula in the Act.
How leave encashment is taxed
During service
Some employers allow you to encash unused leave at year-end or any other interval while you are still on the rolls. This is fully taxable as salary income under Section 17(1). Your employer adds the amount to your gross salary, computes the average tax rate, and deducts TDS under Section 192. No part of this is exempt.
At retirement or resignation
When you separate from service, whether by retirement, voluntary retirement, resignation, or termination, Section 10(10AA) provides relief. The exempt amount is the least of four numbers — actual leave encashment received, average salary of the last 10 months times the eligible leave balance in months, Rs. 25,00,000 (the new specified limit), and 10 months of average salary.
Government employees
For Central Government, State Government, and certain semi-government employees, the entire leave encashment at retirement is fully exempt under Section 10(10AA)(i). There is no upper cap. This is one of the most generous retirement benefits available to government employees.
The Rs. 25 lakh limit in detail
How the limit was set
Before April 2023, the limit for non-government employees was just Rs. 3 lakh. CBDT Notification 31/2023 raised it to Rs. 25 lakh effective from FY 2023-24 onwards. The change made a meaningful difference for retiring private sector employees who had accumulated decades of leave.
Cumulative across employers
The Rs. 25 lakh limit is a lifetime cumulative cap. If you received Rs. 10 lakh as exempt leave encashment when you left your first job, you have only Rs. 15 lakh of exemption left for any future job change or retirement. The CBDT specifically clarified this in its notification.
The four-cap test
In the formula, the exemption is the least of the four amounts. So even if you have not used the Rs. 25 lakh cap, your actual exemption could be lower if your average salary is modest or your leave balance is small. Most private sector employees end up exempt below Rs. 10 lakh in practice.
How TDS is calculated by your employer
Computation at the time of separation
At the time of full and final settlement, your employer applies Section 10(10AA) and computes the exempt portion. The taxable balance is added to your other salary income for the year, and TDS is deducted at your average rate. The exemption is reflected in Form 16 Part B under "less exemptions" along with HRA and gratuity.
Documentation
Keep a record of any earlier leave encashment exemption claimed from previous employers. Self-declarations to your new employer about earlier exemptions are needed so they correctly apply the cumulative cap. Without this, employers may apply the full Rs. 25 lakh again, leading to a tax demand at ITR filing.
Mid-year resignation
If you resign in mid-FY 2025-26 and join a new job, the leave encashment received at separation is taxed in this year. Your new employer will need a copy of your Form 16 from the previous employer to consolidate income and apply correct TDS for the remaining months.
A real example
Meera, 58, Rs. 32L current CTC, Mumbai, retires from her HR Director role at a private bank in February 2026 after 28 years of service. She has accumulated 240 days of unused earned leave, eligible for encashment. Her average salary in the last 10 months is Rs. 2,40,000 per month (basic plus dearness allowance only).
Here is how Section 10(10AA) plays out:
- Actual leave encashment received: Rs. 19,20,000 (240 days at Rs. 8,000 per day equivalent).
- Average salary times eligible leave in months: Rs. 2,40,000 multiplied by 8 months (240 days), that is Rs. 19,20,000.
- Specified limit: Rs. 25,00,000.
- 10 months of average salary: Rs. 2,40,000 multiplied by 10, that is Rs. 24,00,000.
- The least of these is Rs. 19,20,000, so the entire amount is exempt under Section 10(10AA).
- Her employer reflects this in Form 16 Part B, no TDS on the leave encashment portion.
Now contrast this with her colleague Aditya, 42, Rs. 28L CTC, Mumbai, who resigns to switch jobs in December 2025. He receives Rs. 8 lakh as leave encashment. Because he is not retiring but resigning, Section 10(10AA) still applies, and he is below the Rs. 25 lakh cap. The exempt amount works out to about Rs. 6 lakh based on the formula. The taxable Rs. 2 lakh is added to his salary and TDS is deducted at his slab rate.
What to do this week
- If you are nearing retirement or planning to resign, ask your HR for an estimate of your leave encashment and the exempt portion under Section 10(10AA).
- Maintain records of any earlier leave encashment exemption claimed from previous employers to track your lifetime cap.
- Verify whether your employer is treating you as government or non-government — this distinction can make a huge difference.
- Plan your retirement date strategically if it affects when your leave encashment is received and taxed.
- Run the 6-step assessment at https://myfinancial.in to see your old-vs-new regime delta, unused deductions, and insurance gap in under 10 minutes.
FAQ
Is the Rs. 25 lakh exemption per event or lifetime?
Lifetime cumulative. If you received Rs. 8 lakh as exempt leave encashment at your previous job change, only Rs. 17 lakh of the cap remains available for any subsequent separation. CBDT Notification 31/2023 makes this clear.
Does the exemption apply if I resign rather than retire?
Yes. Section 10(10AA)(ii) applies to non-government employees on retirement, whether on superannuation or otherwise. Resignation is included. Termination by the employer also qualifies for the exemption.
What if my employer does not consider Section 10(10AA) while deducting TDS?
You can still claim the exemption while filing your ITR. Reflect the gross leave encashment in your salary income and claim the exempt portion as Section 10(10AA) deduction. Keep your final settlement statement as proof.
Does Section 10(10AA) apply under the new tax regime?
Yes. Section 10(10AA) exemption is available under both old and new tax regimes for AY 2026-27. Unlike many other exemptions, this one survives the regime switch.
What happens if I encash leave during service?
Fully taxable. There is no Section 10(10AA) exemption during service. Your employer treats the encashed amount as part of your salary and applies TDS under Section 192 at your average rate.
How is the average salary computed for the formula?
Average salary is based on basic salary plus dearness allowance (forming part of retirement benefits) plus commission paid as a fixed percentage of turnover, averaged over the last 10 months immediately preceding the date of retirement.
Can I claim Section 10(10AA) for family pension leave encashment?
No. Section 10(10AA) is specifically for leave encashment received by the employee on retirement. Amounts received by the family or legal heirs after the employee's death are governed by other provisions.
Sources
- Income Tax Department, Section 10(10AA): https://incometax.gov.in/
- CBDT Notification 31/2023 on leave encashment limit: https://incometax.gov.in/iec/foportal/
- TRACES, TDS information: https://www.tdscpc.gov.in/
- Finance Ministry tax announcements: https://finmin.nic.in/
This is general information, not personalised advice. For your situation, consult a Certified Financial Planner.
