Caring for your special needs child can be a challenging task, especially in today’s complex and busy world. Thanks to advances in medical technology, children with special needs, disabilities and chronic illnesses now often outlive their parents. While this is an excellent development, it has created a concern for parents of these children regarding their long term care needs. The biggest concern is how to ensure existing assets and funding are transferred to the children, as well as how these will be administered after the parents are no longer in the picture.
The best solution to this concern is the setting up of a Special Needs Trust (SNT), which allows parents to secure their children’s future in regards to both caregiving as well as funding for their care and living expenses. Setting these trusts up properly can be a difficult task, as it requires not only knowledge surrounding how to transfer assets into a trust but also how to navigate changing tax laws to ensure the child receives the maximum amount of financial support. Because of the complex nature of trusts, it is strongly recommended to work with an experienced attorney specializing in trusts and estate planning.
Types of Trusts
As mentioned above, there are many benefits to setting up a special needs trust for children. One of the biggest benefits is obviously the ability to provide the vital continued medical care and assistance to an adult special needs child. Additionally, it provides a repository for a parent to have their resources placed in order to ensure there will be enough financial support to fund the child’s future, including medical bills, cost of food, housing, etc. Glenn Ruffenach of the Wall Street Journal details this even further in his piece Special-Needs Trusts: How They Work and What Has Changed.
“Two features set a special-needs trust apart. First, a trustee is appointed to manage any and all spending; the beneficiary has no control over the assets inside the trust. Second, the fact that the assets aren’t owned outright by the beneficiary means that he or she remains eligible for government programs that place limits on assets, such as Supplemental Security Income (managed by the Social Security Administration) or Medicaid.”
Special needs trusts are divided up into three main types, depending on the specific goals and needs at hand. These include first party, third party and pooled trusts. First party trusts are intended to be used when the beneficiary has or is expected to receive considerable assets that would otherwise disqualify them from receiving public benefits, such as Supplemental Security Income and Medicaid. These types of trusts are irrevocable, which means once they are set up they cannot be changed. In addition to this, they must be established before the beneficiary reaches the age of 65. A caveat to these trusts is that they can only be funded with the beneficiaries assets, and they do not allow for outside or third party assets.
Third party trusts are by far the most common for special needs situations, as they are set up by a donor. This donor is usually a parent, grandparent or close relative, however it can be anyone. Most donors have a third party trust included in their estate plan in order for their special needs child to be cared for both while the donor is still living and after they pass. Third party trusts can also be the beneficiaries of life insurance policies, and can own real estate or investments and are even eligible to receive benefits from retirement accounts. There is no limit to the size of a third party trust, so they can become quite large depending on how many sources of income it has.
One of the key advantages of a third party trust is that unlike all other types of trusts, the government is not entitled to reimbursement for medicaid payments that are made on behalf of the beneficiary after the beneficiary passes. This gives savvy donors the ability to provide benefits to their special needs child while saving funds for others who don’t require special care later on down the road. Another advantage is that while the donor is living, all funds in the trust only generate income tax for the donor themselves, not the beneficiary. This saves the hassle and confusion of having to file taxes for an otherwise non-taxable beneficiary.
Pooled trusts are the most complex of special needs trusts, and also the most unique. Unlike first or third party trusts, pooled trusts are not established by an individual such as a beneficiary or donor but are instead set up by a non-profit organization, with many individual beneficiaries creating their own accounts within a trust. Because these trusts have many accounts combining assets together, they are considered to be pooled, hence the name. As a result of accepting so many contributions from different beneficiaries, these trusts are able to make more stable investments and provide additional management services that would otherwise not be available in smaller trusts. Like all of the trusts discussed, pooled trusts do not prevent a beneficiary with special needs from being eligible for government benefits.
Funneling Retirement Accounts into SNT
Many parents and donors are interested in funneling their IRAs and other retirement accounts into their child’s special needs trust after they pass. While this is possible, it must be set up the right way in order to work properly. This has to do with the way the IRA is structured, how the beneficiary is classified in the tax code, as well as the type of IRA used.
Regardless of the type of IRA used, it is not possible to “assign” it to a special needs trust. Instead, it must be set up so that it names a special-needs trust as a beneficiary to be paid out when the IRAs owner passes away. This will allow withdrawals from the IRA to be paid directly into the trust, which in turn will provide financial benefits to the special needs child. It should be noted that when the parent or donor passes away, the IRA becomes an “inherited IRA”, which means it’s required to pay out minimum distributions to the beneficiary, in this case the SNT.
Due to recent changes in federal retirement account law as a result of the 2019 enactment of the SECURE Act, IRAs must be paid out within ten years of the account owner’s passing. This effectively eliminated the stretch IRA which allowed beneficiaries to withdraw over their lifetime. However, there is an exception for special needs trusts when their beneficiaries are legally defined as “disabled” or “chronically ill” per U.S.C Title 26. This allows SNTs to withdraw from the inherited IRA throughout the special needs child’s lifetime, effectively bringing back the stretch IRA. In order for a beneficiary to qualify for this they must fall within sections 72(m)(7) and 7702B(c)(2) of the tax code, which in most cases will require a doctor’s certification.
Another thing to keep in mind in regards to using IRAs to fund a SNT after a parents passing is that there can be significant tax liabilities depending on how large the IRA is at the time of the donor’s death. The larger the IRA, the larger the required minimum distributions to the trust, which when held in the trust instead of being passed directly to the beneficiary can result in serious tax bills.
A couple of alternatives that are better suited for large retirement accounts are Roth IRAs and life insurance. With Roth IRAs, required distributions are considered income tax free, eliminating tax concerns. Life insurance is even more straightforward in that there are no required distributions which lessens the chance of unexpected tax liabilities. Many donors with sizable retirement accounts wisely chose to convert their traditional IRAs into either of these two alternatives in order to maximize the benefits their children receive from their special needs trusts.