Leave encashment exemption Rs 25 lakh under Section 10(10AA): the 2023 raise, retirement vs in-service treatment

For 21 years between 2002 and 2023, the Section 10(10AA) leave encashment exemption for non-government retirees was frozen at Rs 3 lakh. CBDT Notification S.O. 2276(E) No. 31/2023 dated 24 May 2023 lifted it to Rs 25 lakh, an 8.3x jump, effective for retirements on or after 1 April 2023. As of 21 May 2026 the Rs 25 lakh ceiling remains the prevailing statutory cap. For a senior employee retiring with 28 to 35 years of unused privilege leave and a basic-plus-DA in the Rs 1.5 to Rs 2.5 lakh per month band, this single change can mean the difference between paying 30% slab tax on a Rs 22 lakh terminal payout and walking away with the entire amount net of tax.

The catch: most retirees still get the formula wrong, because Section 10(10AA) does not give you a Rs 25 lakh exemption; it gives you the least of four numbers, and Rs 25 lakh is only one of them. This guide breaks down the four-pronged test, the in-service trap that catches mid-career switchers, the inter-employer lifetime aggregate that few HR teams flag, and a worked example for a private-sector retiree drawing down post-retirement.

The Scheme Explained

Section 10(10AA) of the Income Tax Act 1961 deals exclusively with the cash equivalent of unutilised earned leave paid to an employee at retirement, superannuation, resignation, or death. It has two limbs.

Limb (i) — Central and State Government employees. The entire leave encashment received on retirement is exempt without any ceiling. There is no four-test arithmetic; the gross amount flows to Income from Salaries with full exemption claimed under Section 10(10AA)(i).

Limb (ii) — All other employees. Private-sector employees, employees of statutory corporations not deemed government, and employees of foreign companies operating in India fall here. The exemption is the least of four amounts:

1. The actual leave encashment received from the employer on retirement or resignation;
2. Rs 25 lakh, the statutory ceiling notified under Section 10(10AA)(ii) by CBDT Notification 31/2023;
3. Ten months' average salary, where average salary means basic pay plus dearness allowance forming part of retirement benefits plus commission paid as a fixed percentage of turnover, averaged over the ten months immediately preceding the date of retirement;
4. The cash equivalent of unutilised earned leave standing to credit on the date of retirement, computed at not more than 30 days per completed year of service.

The first three are taxpayer-friendly limits; the fourth is the actual leave-balance calculation. If your employer allows 45 days per year, only 30 days per completed year qualify for the formula.

CBDT chose Rs 25 lakh to mirror the highest basic pay cap for non-government roles in central public enterprises noted at the time, an alignment principle borne out by the explanatory memorandum. The same approach was used in 2018 when the gratuity ceiling under Section 10(10)(iii) was raised to Rs 20 lakh, though the two limits operate independently. Leave encashment uses Rs 25 lakh; gratuity uses Rs 20 lakh.

There is one further trap. The Rs 25 lakh under Section 10(10AA)(ii) is a lifetime aggregate across all employers, not a per-employer figure. Section 10(10AA) Explanation (ii) reduces the available ceiling at the next event by amounts already claimed from any former employer. A 52-year-old who claims Rs 8 lakh exempt on quitting Employer A has only Rs 17 lakh of ceiling left when he retires from Employer B at 60.

Internal references for the rest of the retirement package: the gratuity calculator for the Section 10(10) Rs 20 lakh ceiling and the retirement drawdown calculator for post-retirement income engineering. The Oquilia gratuity glossary explains why these two exemptions are not interchangeable.

Tax on Withdrawal

Three rules sit on top of the four-test formula and decide what tax you actually pay.

Rule 1: Old vs new regime — both work. Section 10(10AA) is an income-side exemption under Chapter III, not a Chapter VI-A deduction. It survives the new regime under Section 115BAC just like Section 10(10) gratuity, Section 10(10C) VRS, and standard deduction. A 58-year-old retiring in FY 2025-26 who has shifted to the new regime to take the Rs 60,000 Section 87A rebate up to taxable income of Rs 12 lakh does not lose the Rs 25 lakh leave encashment exemption. The exemption applies before slab rates touch the salary income.

Rule 2: In-service encashment is fully taxable. This is the single biggest planning mistake. Section 10(10AA) only activates on retirement, superannuation, resignation, or death. If you are still in the same job and you encash 20 days of accumulated leave, the entire amount is added to Income from Salaries for that financial year and taxed at slab rates. The Rs 25 lakh ceiling is reserved for the terminal event.

Rule 3: Inter-employer aggregation. When you join a new employer, the new payroll team computes your eventual exemption fresh against the Rs 25 lakh ceiling. They do not know what the previous employer paid you. The onus is on you to disclose prior exempt amounts at the next retirement event. The Income Tax Department's AIS now reflects historical Section 10(10AA) exempt amounts where the prior employer filed Form 24Q correctly, so non-disclosure carries detection risk under the e-verification scheme.

The tax on the residual post-exemption leave encashment is salary income for the financial year of retirement. There is no LTCG carve-out and no Section 89(1) relief by default. However, if the encashment relates to multiple years of service and bumps the retiree into a higher slab than would otherwise apply, Section 89(1) read with Rule 21A allows spreading the income across earlier years for relief computation, filed via Form 10E before the ITR.

Worked Drawdown

Consider Mr Bharadwaj, a 60-year-old retiring on 31 March 2026 from a large private bank after 32 completed years of service. His final salary slip shows:

• Basic pay: Rs 1,80,000 per month
• Dearness allowance forming part of retirement benefits: Rs 30,000 per month
• HRA, conveyance, performance bonus: not included in the Section 10(10AA) salary definition
• Average salary over the preceding 10 months (basic + DA only): Rs 2,10,000 per month

His leave records show 480 days of unutilised earned leave on the date of retirement, accumulated over 32 years at an employer-approved 25 days per year, with carryover up to 600 days. Daily rate = (Rs 1,80,000 + Rs 30,000) / 30 = Rs 7,000 per day. Gross leave encashment received = 480 days x Rs 7,000 = Rs 33,60,000.

Now apply the four-test formula under Section 10(10AA)(ii).

The least of the four is limb (c), Rs 21,00,000. That is the Section 10(10AA) exemption Mr Bharadwaj can claim. The remaining Rs 12,60,000 is taxable as Income from Salaries for FY 2025-26. Note how the Rs 25 lakh ceiling, the headline of the 2023 notification, does not even bind here. It is limb (c), the ten-month average salary, that pinches first. This is the typical pattern for senior employees who accumulated leave aggressively.

Compare with a more junior retiree. Mrs Kapoor, 58, retires from a mid-cap manufacturing company on 31 March 2026 after 22 completed years. Her basic + DA averages Rs 90,000 per month. She has 360 days of leave to her credit. Gross leave encashment = Rs 10,80,000. Least of the four limbs is again (c), at Rs 9,00,000 (10 months x Rs 90,000). Taxable balance = Rs 1,80,000 added to her Income from Salaries.

Drawdown sequencing post-retirement. Once the exemption is locked in, the post-tax lumpsum should be deployed alongside the rest of the retirement corpus.

Mr Bharadwaj's Rs 33.60 lakh leave encashment (Rs 21 lakh exempt and Rs 12.60 lakh taxed at marginal 30%, netting roughly Rs 29.82 lakh) is best parked in a 24-month overnight/ultra-short debt fund ladder to fund years 1 to 3 of his drawdown. Use the NPS calculator to size the year-11 onwards annuity outlay and the annuity vs SWP calculator to decide how much corpus to hold back from the mandatory 40% NPS annuity. The EPF maturity number itself depends on the EPFO-declared rate, currently 8.25% for FY 2024-25; cross-reference the EPF glossary before booking it.

FAQ

Is the Rs 25 lakh leave encashment exemption available in the new tax regime?

Yes. Section 10(10AA) is an income-side exemption under Chapter III of the Income Tax Act, not a deduction under Chapter VI-A. Section 80C, 80D, and 80CCD(1B) (the Rs 50,000 additional NPS deduction) are NOT allowed in the new regime because Section 115BAC(1A) disables most Chapter VI-A claims (only 80CCD(2) employer NPS and 80JJAA survive). Section 10 exemptions for gratuity, leave encashment, VRS, and standard deduction, by contrast, survive both regimes. For retirements on or after 1 April 2023 the Rs 25 lakh leave encashment ceiling applies regardless of which regime you have opted into.

Is leave encashment taxable if I take it while still in service?

Yes, in full. The Section 10(10AA) exemption only activates on the terminal event of retirement, superannuation, resignation, or death. Any leave encashed while you continue with the same employer is treated as a salary payment for that financial year and taxed at slab rates. The Rs 25 lakh ceiling is reserved for the final exit; you cannot ration it across mid-career encashments.

Is the Rs 25 lakh ceiling per employer or lifetime?

It is a lifetime aggregate across all employers. Section 10(10AA) Explanation (ii) reduces the Rs 25 lakh ceiling by any amount previously claimed exempt under the same section from any earlier employer. If you claimed Rs 8 lakh exempt on leaving Employer A in 2018, you have only Rs 17 lakh of statutory ceiling left when you retire from Employer B in 2032. The other limbs of the four-test formula run afresh, but the limb (b) ceiling is permanently reduced.

What about leave encashment received by a deceased employee's family?

Leave encashment paid to the legal heirs of an employee who dies in service is fully exempt under Section 10(10AA) without any monetary ceiling. The Rs 25 lakh cap and the four-test formula do not apply to death-in-service payouts. This is a separate statutory carve-out reflecting humanitarian principles in the income tax code.

Does the exemption cover earned leave only, or sick and casual leave too?

Only earned leave (also called privilege leave or annual leave) qualifies under Section 10(10AA). The cash equivalent is further capped at 30 days per completed year of service in limb (d) of the formula. Sick leave, casual leave, study leave, and any earned leave above 30 days per completed year are stripped out before the four-test runs.

Where does leave encashment sit on the ITR form?

In ITR-1 or ITR-2 the gross leave encashment is reported within the salary schedule (the figure flows from Form 16 Part B), and the exempt portion under Section 10(10AA) is captured in the row titled "Allowances to the extent exempt under Section 10". The taxable residual flows into Income from Salaries and is taxed at the applicable slab. If the encashment relates to multiple years and would push you into a higher slab than the spread-back average, file Form 10E before the ITR to claim Section 89(1) relief.