Salary Income Under Income Tax Act 2025 — Complete Guide to Computation & Changes | Virtual Auditor

HRA Computation Example

Mr. Ramesh works in Mumbai. His annual salary details: Basic Pay = ₹6,00,000; DA (forming part) = ₹1,20,000; HRA received = ₹3,60,000; Rent paid = ₹32,500 per month (₹3,90,000 per year).

• (a) Actual HRA received = ₹3,60,000
• (b) 50% of salary (Mumbai — metro) = 50% of ₹7,20,000 = ₹3,60,000
• (c) Rent paid minus 10% of salary = ₹3,90,000 – ₹72,000 = ₹3,18,000

Exempt HRA = ₹3,18,000 (minimum of the three). Taxable HRA = ₹3,60,000 – ₹3,18,000 = ₹42,000.

Important: If the employee changes cities during the year, the HRA exemption must be calculated separately for the period spent in each city using the respective percentage (50% or 40%). Also, employees must report the landlord’s PAN if annual rent exceeds ₹1,00,000 — failure to do so makes the claim inadmissible.

6. Leave Travel Allowance (LTA)

LTA exemption is available only under the old regime. The exemption covers the cost of travel (air, rail, or bus fare) for the employee and their family for two journeys in a block of four calendar years. The current block period is 2026–2029. Key conditions:

• Only domestic travel within India qualifies — foreign travel is not covered
• Actual travel must be undertaken — encashment without travel is fully taxable
• Air fare is restricted to economy class; rail fare to AC first class
• If travel is to a place not connected by rail, the exemption is limited to the AC first class rail fare of the distance by shortest route or the amount actually spent, whichever is lower
• One unused journey in a block can be carried forward to the first year of the next block only
• “Family” includes spouse, two children (born after 1 October 1998, only two eligible), and dependent parents and siblings

7. Perquisite Valuation Rules

Perquisites are non-cash benefits provided by the employer. The Income Tax Act 2025 prescribes specific valuation rules. The employer must compute the perquisite value and include it in the Form 16 issued to the employee:

Non-taxable perquisites: Medical treatment in employer hospital or approved hospital, medical insurance premium paid by employer, recreational facilities available uniformly to all employees, employer contributions to approved PF and superannuation fund up to prescribed limits, and leave travel concession within the exemption limits.

8. ESOP Taxation — Exercise, Sale & Startup Deferral

Employee Stock Option Plans (ESOPs) create two distinct taxable events in the income tax framework:

8.1 At Exercise — Perquisite Tax

When the employee exercises the option and acquires shares, the difference between the Fair Market Value (FMV) on the date of exercise and the exercise price (amount paid by the employee) is taxed as a perquisite under salary. The employer must deduct TDS on this perquisite value at the time of exercise or at the time the shares are allotted, whichever is later. For listed shares, FMV is the average of the opening and closing price on the date of exercise on the recognised stock exchange. For unlisted shares, FMV must be determined by a SEBI-registered merchant banker as on the date of exercise.

8.2 At Sale — Capital Gains

When the employee subsequently sells the shares, capital gains tax applies. The cost of acquisition for capital gains purposes is the FMV on the date of exercise (the value on which perquisite tax was already paid). The holding period is calculated from the date of exercise (not grant date) to the date of sale. For listed shares held beyond 12 months, LTCG at 12.5% applies; for unlisted shares, the holding period threshold is 24 months.

8.3 DPIIT Startup Deferral

For employees of eligible startups recognised by DPIIT under the Startup India scheme, the employer is not required to deduct TDS on the ESOP perquisite at the time of exercise. Instead, the TDS obligation is deferred to the earliest of: (a) expiry of 5 years from the date of allotment, (b) date of sale of the shares by the employee, or (c) date on which the employee ceases employment with the eligible startup. This provision addresses the cash-flow problem where employees had to pay tax on notional paper gains without actually realising any cash from the shares. Under the 2025 Act, this deferral is now a permanent provision rather than a sunset-linked benefit.

9. Gratuity Exemption — ₹25 Lakh Limit

Gratuity is a lump-sum payment made by the employer to an employee on retirement, superannuation, resignation (after minimum 5 years of continuous service), or death. The tax treatment differs by category:

Key points: (i) “Last drawn salary” for Gratuity Act covered employees means basic pay plus dearness allowance only. (ii) For employees not covered by the Gratuity Act, “average salary” is the average of basic plus DA for the 10 months immediately preceding the month of retirement. (iii) The ₹25 lakh limit is a lifetime aggregate — if gratuity is received from multiple employers over a career, the total exemption across all instances cannot exceed ₹25 lakh. (iv) In case of death, the minimum service condition of 5 years is waived.

10. Leave Encashment — ₹25 Lakh Exemption

Leave encashment received during employment is fully taxable irrespective of the regime chosen. Leave encashment received on retirement or leaving service enjoys exemption:

• Government employees: Fully exempt with no monetary ceiling
• Non-government employees: Exempt amount is the least of:
  • ₹25,00,000 (aggregate lifetime limit across all employers)
  • Actual leave encashment received
  • 10 months’ average salary (basic + DA for last 10 months)
  • Cash equivalent of leave standing to credit at retirement — computed as earned leave balance multiplied by average daily salary, subject to a maximum of 30 days’ leave per completed year of service

The ₹25 lakh limit was a significant improvement, raised from the ₹3 lakh ceiling that had remained unchanged since 2002. The increase was first introduced via government notification dated 24 May 2023 and is now codified in the Income Tax Act 2025.

11. Commutation of Pension

Regular pension (monthly payments) is fully taxable as salary income and qualifies for the standard deduction. However, commuted pension (lump-sum encashment of future pension entitlement) enjoys the following exemption:

Additional pension provisions: (i) Annuity received from a superannuation fund is taxable as salary. (ii) Commuted value received from an approved superannuation fund is partially exempt. (iii) NPS withdrawals at maturity — 60% of the corpus withdrawn as lump sum is fully exempt; the remaining 40% must be used to purchase an annuity, and the annuity income received periodically is taxable as salary. (iv) Family pension received by a dependent after the employee’s death is taxable as income from other sources, not salary, and qualifies for a deduction of ₹15,000 or one-third of the pension, whichever is lower.

12. Component-wise Taxability: New Regime vs Old Regime

13. Numerical Example — Complete Salary Computation

Ms. Priya works in Bengaluru (non-metro). Her FY 2025-26 salary details: Basic Pay ₹9,00,000; DA (forming part of retirement benefits) ₹1,80,000; HRA ₹4,50,000; Special Allowance ₹1,20,000; LTA ₹40,000. She pays rent of ₹32,500 per month (₹3,90,000 per year) and has undertaken domestic travel costing ₹38,000.

HRA exemption working (old regime): Salary for HRA = Basic + DA = ₹10,80,000. (a) Actual HRA = ₹4,50,000; (b) 40% of salary (Bengaluru — non-metro) = ₹4,32,000; (c) Rent paid minus 10% of salary = ₹3,90,000 – ₹1,08,000 = ₹2,82,000. Exempt HRA = minimum of the three = ₹2,82,000.

After this, under the old regime Ms. Priya can claim Chapter VI-A deductions (for instance ₹1,50,000 under section 80C, ₹25,000 under 80D for health insurance, and ₹50,000 for NPS under 80CCD(1B)). Under the new regime, only employer NPS contribution is deductible. The final tax liability depends on the applicable tax slab rates for the chosen regime.

14. What Changed from the 1961 Act

• Standard deduction enhanced: ₹75,000 under the new regime (was ₹50,000 uniformly under the 1961 Act for both regimes)
• New regime as default: The new regime is the default under the 2025 Act; employees must opt out by filing Form 10-IEA before the ITR due date to use the old regime. Under the 1961 Act, the old regime was the default until AY 2024-25
• Gratuity exemption limit raised: ₹25 lakh under the 2025 Act, up from ₹20 lakh under the 1961 Act
• Leave encashment limit codified: ₹25 lakh codified directly in the statute (previously raised via notification in May 2023 from ₹3 lakh)
• Employer NPS contribution unified: 14% of salary exempt under both regimes — a uniform limit replacing the bifurcated 10% (private) and 14% (government) structure
• ESOP deferral made permanent: The startup ESOP deferral was a temporary provision under section 191(2) of the 1961 Act; the 2025 Act makes it a permanent statutory provision
• Simplified provisions: Sections renumbered, salary provisions consolidated, and language modernised with reduced cross-references to improve readability
• Provident fund interest cap: Interest on employee contribution to PF exceeding ₹2.5 lakh per year remains taxable, carried forward from the 2021 amendment into the new Act

Disclaimer: This article is for educational purposes and does not constitute professional tax advice. Tax laws are subject to amendments and judicial interpretation. Consult a qualified Chartered Accountant for advice specific to your situation. For professional assistance, contact Virtual Auditor.