TAX ON RETIREMENT BENEFITS for FY 2025-26

Tax on Retirement Benefits FY 2025-26 explains how gratuity, leave encashment, commuted pension and VRS compensation are taxed, including key exemptions and limits for FY 2025-26.

Each of the retirement benefit like gratuity , commuted pension , leave encashment and provident fund have separate treatment for tax purpose and read the article for taxes and exemptions on each of them

The Article on ” TAX PLANNING FOR FY 2025-26  CONTAINS 11  PARTS

 PART I: MAJOR CHANGES IN TAX RULES FOR FY 2025-26 

 PART 2 : TAX SLABS /RATES FOR FY 2025-26

​ PART 3 : TAX REBATES FOR FY 25-26 

PART 4 :  CAPITAL GAIN TAX  FOR FY 2025-26

PART 5 : TAX ON  SALE OF RESIDENTIAL PROPERTY 

PART 6 :  TAX ON MUTUAL FUNDS

PART 7:   TAX ON INSURANCE

PART 8 : INCOME TAX CALCULATOR FOR FY 2025-26

PART 9 : TAX ON RETIREMENT BENEFITS FOR FY 2025-26

PART 10 : HOW TO PAY INCOME TAX ONLINE? 

PART 11 : ​TO KNOW ALL ABOUT TDS RATES , 

PART  9 :   TAX ON RETIREMENT  BENEFITS

TAX ON LEAVE ENCASHMENT  

Tax on leave encashment for FY 2025-26 (Assessment Year 2026-27) follows the rules set by the major revision in 2023, with no specific new changes to the exemption limits in the 2025 Budget. However, your overall tax liability may change due to new tax slabs.

The taxability depends entirely on your employment type

1. Government Employees

For Central and State Government employees, leave encashment received at the time of retirement or superannuation is fully exempt from income tax. There is no upper limit on the amount.

2. Non-Government (Private) Employees

For private-sector employees, the exemption is provided under Section 10(10AA). The amount exempt from tax is the least of the following four values:

1. Actual amount received as leave encashment.
2. Statutory Limit: ₹25 Lakh (This was increased from ₹3 Lakh to ₹25 Lakh in 2023 and remains the same for FY 2025-26).
3. 10 Months’ Average Salary: Based on the average salary of the last 10 months immediately preceding retirement.
4. Cash equivalent of leave balance: Calculated based on a maximum of 30 days of leave for every completed year of service.

Note: “Salary” for this calculation = Basic + Dearness Allowance (DA). Any commission based on turnover is also included if it’s a fixed percentage

Important Notes : 

• During Service: If you encash your leaves while you are still working (not retiring), the entire amount is fully taxable as “Income from Salary.” No exemption applies.
• Resignation vs. Retirement: The exemption is available even if you resign or leave your job for reasons other than age-related retirement.
• Lifetime Limit: The ₹25 Lakh limit is a lifetime limit. If you claimed an exemption of ₹10 Lakh from a previous employer, you only have ₹15 Lakh of exemption limit left for your current retirement.
• Legal The most significant update for 2025 is the implementation of the New Social Security Code, which has changed how gratuity is calculated and who is eligible.Heirs: If leave encashment is paid to the family of a deceased employee, the entire amount is 100% tax-free for the heirs

TAX ON GRATUITY 

For the Financial Year 2025-26 (Assessment Year 2026-27), the taxation of gratuity depends primarily on your employment category and the tax regime you choose.

1. Exemption Limits (FY 2025-26)

Note: For private sector employees, the ₹20 lakh limit is a lifetime cap. If you have claimed ₹5 lakh in a previous job, your remaining tax-free limit for future gratuity is ₹15 lakh

2. Calculation Formulas

To find out how much of your gratuity is tax-free, the law considers the least of these three amounts:

1. Actual gratuity received.
2. The statutory limit (₹20 Lakh).
3. The amount calculated via the formula

A. For Employees Covered by the Gratuity Act

Exemption = 15/26 times (Basic+ DA}) times Years of Service

• Service Year Rule: If you worked for more than 6 months in your final year (e.g., 10 years and 7 months), it is rounded up to 11 years.

• B. For Employees NOT Covered by the Act

Exemption= ½  times Avg. Salary of last 10 months times Completed Years of ServiceService Year Rule: Only fully completed years are counted (e.g., 10 years and 9 months is treated as 10 years).

3. Important Changes in 2025 (Labour Codes)

The Social Security Code 2020, which became fully active in late 2025, introduced two major shifts:

• The 50% Wage Rule: Your “wages” for gratuity calculation must now be at least 50% of your total CTC. If your basic pay is very low and allowances are high, your company must adjust the calculation to include the excess allowances, leading to a higher gratuity payout (and potentially higher tax if it exceeds ₹20 lakh).
• Fixed-Term Employees: If you are on a fixed-term contract, you are now eligible for gratuity after just 1 year of service, instead of the traditional 5-year requirement.

4. Old vs. New Tax Regime

A common question is whether you lose this exemption in the New Tax Regime.

• Gratuity Exemption (Sec 10(10)) is ALLOWED in both regimes. Unlike HRA or LTA (which are lost in the New Regime), terminal benefits like Gratuity, Leave Encashment, and VRS remain tax-exempt up to their respective limits even if you opt for the New Tax Regime.

Summary of Rules on Gratuity

• Private sector limit: ₹20 Lakh.
• Govt sector: Fully exempt (Central Govt limit for receipt is now ₹25 Lakh).
• New Rule: Gratuity is now calculated on at least 50% of your CTC.
• Eligibility: 5 years for permanent staff; 1 year for fixed-term staff.

TAX ON COMMUTED PENSION  FOR  FY 2025-26

When you retire, you can choose to receive your pension in two ways:

• Uncommuted Pension: Monthly payments (like a salary). This is fully taxable for everyone under the head “Income from Salaries.”
• Commuted Pension: A lump sum amount received by “selling” or surrendering a portion of your future monthly pension in advance

Tax on commuted pension for FY 2025-26 (Assessment Year 2026-27) has undergone a historic shift aimed at creating parity between government and private-sector employees.

Major Update for FY 2025-26

Historically, private-sector employees were only partially exempt, while government employees were fully exempt. Under the Income Tax updates of 2025, this gap has been largely closed:

Government Employees: Continue to enjoy 100% tax exemption on the commuted pension amount. This includes employees of the Central/State Government, Local Authorities, and Statutory Corporations.

Non-Government (Private) Employees: Under the new provisions for FY 2025-26, the entire commuted pension is now fully exempt from tax, provided it is received from an approved pension fund (such as those managed by LIC or other IRDAI-regulated insurers).
If not using an “Approved Fund” (The Old Rules still apply):

If your commutation does not fall under the new 100% exemption criteria, the traditional limits apply:

If you receive Gratuity: Only 1/3rd (33.33%) of the full value of the pension is exempt.

If you do NOT receive Gratuity: 1/2 (50%) of the full value of the pension is exempt.

3. Impact of the New Tax Regime (FY 2025-26)

Since the New Tax Regime is now the default, here is how it interacts with your pension:

• Exemption Availability: The exemption on commuted pension (Section 10(10A)) is available under both the Old and New Tax Regimes.
• Higher Standard Deduction: Salaried pensioners can now claim a Standard Deduction of ₹75,000 (increased from ₹50,000) under the New Tax Regime.
• Zero Tax Threshold: If your total taxable income (including uncommuted pension) is up to ₹12.75 Lakh, your effective tax liability will be zero after the standard deduction and Section 87A rebate.

TAX ON VOLUNTARY RETIREMENT / SEPARATION

Benefits received under a Voluntary Retirement Scheme (VRS) or Voluntary Separation Scheme (VSS) are often referred to as a “Golden Handshake.” For FY 2025-26, the tax treatment remains largely the same in terms of limits, but the overall tax impact depends on the updated slabs. The compensation received is exempt from tax under Section 10(10C), subject to the following rules:

1. The Exemption Limit

The maximum amount you can claim as tax-exempt is ₹5 Lakh.

• Any amount received above ₹5 Lakh is added to your income and taxed at your applicable slab rate.
• Important: This is a lifetime exemption. If you have claimed a VRS exemption in a previous job, you cannot claim it again

2. Eligibility Criteria (Rule 2BA)

To qualify for this tax exemption, the voluntary separation must follow specific government guidelines:

• The “40/10” Rule: The employee must be at least 40 years of age OR have completed 10 years of service. (Note: This rule does not apply to employees of Public Sector Undertakings).
• Company Type: You must be an employee of a PSU, a Company, a Local Authority, a Co-operative Society, or a specified Institute of Management/Technology.
• Reduction in Strength: The scheme must be designed to reduce the overall strength of the company.
• No Re-employment: The vacancy caused by your exit must not be filled, and you cannot be re-employed by the same management or a sister concern.

3. Maximum Compensation Allowed

The compensation paid by the company for the purpose of this tax exemption must not exceed the higher of:

1. 3 months’ salary for every completed year of service.

2. Salary at the time of retirement multiplied by the number of months of service left before the actual date of superannuation

4. New Tax Regime vs. Old Tax Regime (FY 2025-26)

One of the most common points of confusion is whether you lose this benefit in the New Tax Regime.

• VRS Exemption is ALLOWED in both regimes. Just like Gratuity and Leave Encashment, the ₹5 Lakh VRS exemption is one of the few benefits retained under the New Tax Regime.
• Relief Under Section 89: You can choose either the Section 10(10C) exemption OR claim tax relief under Section 89 (which spreads the tax burden over several years). You cannot claim both.

SUMMARY OF  TAX  RULES ON RETIREMENT BENEFITS

 THIS  ARTICLE CARRIES INFORMATION ON VARIOUS TAX PROVISIONS WHICH ARE GENERALLY USEFUL . YET IT DOES NOT CARRY ALL THE PROVISIONS AND HENCE YOU ARE ADVISED TO GO THROUGH INCOME TAX DEPARTMENT WEBSITES FOR AUTHENTIC COMPLETE INFORMATION .YOU MAY ALSO CONSULT A QUALIFIED TAX CONSULTANT /CHARTERED ACCOUNTANT FOR ANY CLARIFICATION.READERS ARE ALSO WELCOME TO SEND FEEDBACK ,FORM AVAILABLE BELOW .WE ARE OPEN FOR CORRECTION IF NEEDED

This article is for informational purposes only. It summarises updates from publicly available sources and AI-generated insights. We have extensively used information gathered from a reputed AI app in preparing this article We are not SEBI-registered investment advisors, and this content does not constitute investment advice