I added VPCSecurity group instead of DB Security group that I was using earlier and that fixed the issue, but Update stack will not work in this case and Stack has to be recreated.
Response from AWS Tech Support:
However in your case you are still using the stack which was created initially using DBSecurityGroups property. So this has created legacy CloudFormation which is not aware about the new features including encryption. Therefore I would suggest to delete the existing stack and deploy the new stack using same template.
Our team is aware about this issue and it is being worked internally. We have already updated the documentation with this information:
http://docs.aws.amazon.com/AWSCloudFormation/latest/UserGuide/aws-properties-rds-database-instance.html#cfn-rds-dbinstance-dbsecuritygroups
http://docs.aws.amazon.com/AWSCloudFormation/latest/UserGuide/aws-properties-rds-database-instance.html#cfn-rds-dbinstance-vpcsecuritygroups
I have passed informed my internal team that once the stack is created using DBSecurityGroups, changing this to VPCSecurityGroups will not enable features mentioned above. The only option is to delete the stack and recreate it.