Retirement Savings and Income Planning

Priya, aged 58, separated from service with her employer this year and took a lump-sum distribution of her entire 401(k) balance in one taxable year. The distribution included employer stock with a plan cost basis of $180,000 and a fair market value of $500,000 on the date of distribution. She transferred the stock in kind to a taxable brokerage account and elected net unrealised appreciation treatment, and she rolled the remaining plan assets directly to a traditional IRA. Eight months later she sold all of the employer stock for $560,000. How is the $380,000 of total gain recognised on that sale treated?

• A$320,000 is long-term capital gain and $60,000 is short-term capital gaincheck_circle Correct
• B$380,000 is long-term capital gain and no part of the gain is short-term
• C$320,000 is short-term capital gain and $60,000 is short-term capital gain
• D$320,000 is long-term capital gain and $60,000 is taxed as ordinary income

Why A is correct: The net unrealised appreciation of $500,000 minus $180,000, or $320,000, is long-term capital gain when the stock is sold irrespective of how long Priya held it after the distribution, while the further $60,000 of appreciation earned after the distribution takes its own holding period, which is eight months and therefore short-term.

Why B is wrong: This is tempting because the automatic long-term character of net unrealised appreciation is the memorable part of the rule, but that character attaches to the $320,000 measured at the distribution date, and appreciation arising after the distribution is governed by the ordinary holding period rules.

Why C is wrong: A candidate who applies the eight-month post-distribution holding period to the whole gain reaches this answer, but net unrealised appreciation is treated as long-term capital gain by statute, so the holding period after the distribution does not govern that portion.

Why D is wrong: This confuses the ordinary income element with the post-distribution growth, because the amount taxed as ordinary income under the election is the $180,000 plan cost basis reported in the year of the lump-sum distribution, not the appreciation that accrued in the taxable account afterwards.