Received gratuity, leave encashment or salary arrears? One tax mistake could prove costly

Since India follows slab-based taxation for individuals, such one-time payments may push the taxpayer into a higher tax slab, even though the income may relate to earlier years or may be in the nature of retirement/terminal benefits. 

Accordingly, taxpayers should carefully evaluate whether any exemption or relief is available before filing the income-tax return for AY 26-27 for lump sum receipts such as salary arrears, advance salary, gratuity, leave encashment, commuted pension or compensation on termination of employment, which may significantly increase the taxable income of an individual in the year of receipt. 

However, they should be aware that they don’t necessarily have to pay tax at the higher rate on the entire amount. The Income Tax Act provides relief provisions that can help you reduce the additional tax burden arising from such lump sum receipts.

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In case of salary arrears or advance salary, relief may be claimed under Section 157 of the Income‑tax Act, 2025 (corresponding to Section 89 of the Income-tax Act, 1961). The objective of this relief is to neutralise the additional tax burden arising merely because income pertaining to earlier years has been taxed in one year due to delayed receipt. 

Broadly, the tax payable is recomputed by allocating the arrears to the relevant previous years to which they pertain, and the excess tax impact, if any, is allowed as relief in the year of receipt.

“To claim such relief, the taxpayer is required to file Form 39 (previously Form 10E) electronically on the income-tax e-filing portal. It is advisable to file such a form before filing the income-tax return, as the relief claimed under Section 89 may not be allowed during processing if the prescribed form is not filed,” said CA (Dr.) Suresh Surana.  

Employees may also share the relevant details with their employer so that the relief can be considered at the TDS stage, wherever feasible.

For gratuity, the tax treatment depends on the nature of employment and the applicable category of employee. 

Gratuity received by Government employees is generally exempt, whereas for non-Government employees, exemption is available subject to the limits and conditions prescribed under Section 19 of ITA 2025 (corresponding to Section 10(10) of ITA 1961). 

Currently, the exemption limit for eligible non-Government employees is generally capped at Rs. 20 lakh, subject to the applicable computation mechanism. Any amount exceeding the eligible exemption is taxable as salary income.

“Similarly, other lump sum retirement benefits such as leave encashment, commuted pension, voluntary retirement compensation or retrenchment compensation may also be eligible for specific exemptions under the Income-tax Act, subject to prescribed limits and conditions,” stated Surana.  

Therefore, the nature of the receipt, timing of receipt, employment category, service period and supporting documentation should be reviewed carefully.

Common mistakes taxpayers make while claiming relief under Section 89

Taxpayers often make procedural and computational errors while claiming relief under Section 89 of the ITA 1961 (corresponding to Section 157 of the ITA 2025), which can lead to the denial of the benefit. Some common mistakes to avoid are as follows:

Non‑filing of Form 10E: Claiming relief in the ITR without filing Form 10E (corresponding to Form 39 of ITR 2026), which leads to disallowance of the claim.

Filing Form 10E after ITR: Not submitting the form before filing the return, which is a procedural requirement.

Incorrect allocation of arrears: Failing to properly distribute income across the relevant years to which it pertains.

Errors in computation: Using incorrect figures or not following the prescribed calculation method.

Insufficient documentation: Not maintaining salary statements, employer certificates, or breakup details to substantiate the claim.

How to minimise tax liability on one-time retirement receipts?

Retirees receiving one-time retirement receipts should first identify the exact nature of each receipt, as the tax treatment may differ depending on whether the amount represents gratuity, leave encashment, commuted pension, provident fund withdrawal, voluntary retirement compensation, retrenchment compensation, salary arrears or any other terminal benefit. 

These amounts are not always fully taxable, and the availability of exemption or relief depends on the category of employee, nature of employer, period of service, applicable limits, and the conditions prescribed under the Income-tax Act, 1961.

Further, retirees should compare their tax liability under the old and new tax regimes, particularly where they have deductions such as medical insurance premiums, eligible investments, interest income deductions or other available benefits. 

In many cases, the optimal regime may vary depending on the taxable portion of retirement receipts and other income earned during the year, such as pension, interest income, rental income or capital gains.

“Thus, retirees can minimise tax liability on one-time retirement receipts by correctly identifying the nature of each receipt, claiming all eligible exemptions, filing Form 10E wherever Section 89 relief is applicable, choosing the more beneficial tax regime and ensuring accurate disclosure in the income-tax return,” commented Surana. 

Key things to consider before choosing a regime after receiving a lump-sum payment

Taxpayers receiving a lump-sum payment, such as salary arrears, gratuity, leave encashment, commuted pension, VRS compensation, or other retirement benefits, should not choose the tax regime merely by comparing headline slab rates. 

A detailed computation should be undertaken under both the old and new tax regimes after considering the taxable and exempt portions of the lump-sum receipt.

The first factor to evaluate is the nature of the receipt and whether any specific exemption is available under the Income-tax Act, 1961. 

Surana says, for instance, gratuity, leave encashment, commuted pension, etc. and also examines whether relief under Section 89 is available, particularly where the lump-sum amount represents salary arrears, advance salary, gratuity, commuted pension, etc. 

“This relief may reduce the additional tax burden arising due to taxation of income pertaining to multiple years in a single year. Form 10E should be filed electronically before filing the income-tax return where such relief is claimed,” Surana added. 

Another important factor is the availability of deductions and exemptions under the old regime, such as deductions under Chapter VI-A, medical insurance premiums, interest income deduction, housing loan interest, specified investments, and other eligible claims. 

Since several deductions and exemptions are not available under the new regime, taxpayers with significant eligible deductions may find the old regime more beneficial, even if the new regime offers lower slab rates.

Taxpayers should also consider their other income during the year, such as pension, interest income, rental income, capital gains, and dividend income. A lump-sum receipt may push the taxpayer into a higher slab, affect rebate eligibility, increase surcharge exposure in high-income cases or alter the overall tax outcome. 

Therefore, the regime should be selected only after computing the total tax liability under both options, including surcharge, cess, and available reliefs.

Thus, before choosing a tax regime after receiving a lump-sum payment, taxpayers should evaluate the nature of the receipt, eligible exemptions, applicability of Section 89 relief, availability of deductions under the old regime, other income earned during the year, slab impact, surcharge exposure, and TDS already deducted. 

The preferred regime should be the one that results in a lower overall tax liability after considering all permissible claims and compliance requirements.

Disclaimer: This article is for informational purposes only and does not constitute professional tax advice. Tax laws and regimes are subject to frequent changes by the government. Readers should verify details with official Income Tax Department notifications or consult a Chartered Accountant before making any financial decisions.    

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