IRA Distributions to Special Needs Trusts: Minimizing Income Taxes

For many parents, the majority of their savings is held in some kind of a retirement account, often an Individual Retirement Account (IRA). At age 70 1/2, an IRA account holder faces the Required Beginning Date, when he or she must take mandatory distributions from the IRA. These payments are determined by the government and are known as Required Minimum Distributions.

If the parents have a child with special needs, it is often important for the parents’ estate plan to direct Required Minimum Distributions following the parents’ death into a special needs trust (SNT) that has been set up for the child. For income tax purposes, it is usually best to stretch these distributions out over as long a period as possible, particularly if the IRA is a large one.

How long the distributions can be stretched out depends. Typically, if an IRA account holder names a “designated beneficiary,” the designated beneficiary’s age determines the amount of the distributions. If there is no designated beneficiary, the account must either be paid out in full within five years after the account owner passed away (the “five-year rule”) or over the owner’s remaining life expectancy (the “life expectancy rule”), depending on whether the owner died prior to age 70 ½. If the owner died prior to reaching age 70 ½, the five-year rule applies.  If the owner dies after reaching age 70 ½ , the life expectancy rule applies..

Unfortunately, a poorly drafted SNT may not qualify as a “designated beneficiary” under the IRS rules. As long as all of the SNT’s remainder beneficiaries are individuals, required distributions are allowed to be made based on the age of the eldest potential beneficiary of the trust. The problem is that sometimes SNTs are drafted so that entities that don’t have life expectancies — such as a charity — are potential beneficiaries. In such cases, either the five-year rule or the life expectancy rule applies and the SNT will have to face the income tax consequences of an expedited payout of the IRA.

This is one of the potential IRA pitfalls for “third-party SNTs,” trusts set up and funded by someone other than the child. But when the person with special needs has his or her own assets, a “first-party” or “self-settled” SNT may be more appropriate.

Through careful and complicated tax planning, it may be possible to minimize the income taxes that would otherwise be paid by the SNT on distributions from an IRA into a first-party SNT so long as the trust qualifies as a “grantor trust” — a trust where all income and expenses from the trust count as the grantor’s for income tax purposes. In a first-party SNT, the “grantor” for income tax purposes is the beneficiary.   In such a case, the beneficiary will generally pay the income taxes at a lower tax rate than if the income was taxed to the SNT directly.

If a first-party SNT does not meet the requirements for a grantor trust but the beneficiary meets the definition of being disabled under the Social Security rules, the trust may still be able to take advantage of an additional income tax exemption if the SNT qualifies as a “qualified disability trust.” But a trust can lose this exemption if the beneficiary loses his or her benefits, for whatever reason.

As you can see, the rules governing IRA distributions to SNTs are exceedingly complicated. This is all the more reason to consult with your special needs planner.

End of Year IRA Planning

As the end of the year approaches, and we start thinking about tax season, you should schedule some time to review your past and upcoming financial, estate and asset protection goals.  One area to review, or initiate, is retirement planning with individual retirement arrangements (IRA).  It may be wise to consult with your tax preparer or CPA, financial advisor or estate planning attorney before making any changes.

For 2014 and 2015, your total contributions to all of your traditional and Roth IRAs cannot be more than:

  • $5,500 ($6,500  if you’re age 50 or older), or
  • your taxable compensation for the year, if your compensation was less than this dollar limit.

Your traditional IRA contributions may be tax-deductible.  The deduction may be limited if you or your spouse is covered by a retirement plan at work and your income exceeds certain levels.  You can make 2014 contributions until April 15, 2015.  Also, you can’t make regular contributions to a traditional IRA in the year you reach 70 1/2 and older.  However, you can still contribute to a Roth IRA and make rollover contributions to a Roth or traditional IRA regardless of your age.


Considerations When Designating The Beneficiary Of Your IRA

As more and more workers are saving for retirement through IRA’s and 401(k)s, the question that usually comes up is who should be named as beneficiary.  Who you name as beneficiary and how your pre-tax account is transferred could have significant tax consequences.

  • Spouse As Beneficiary

The simplest yet optimal way to to pass your IRA is to name your spouse as beneficiary.  Your surviving spouse will have four (4) options at your death:

  1. Roll over the assets into a new or existing IRA
  2. Transfer the assets to an inherited IRA
  3. Convert the assets to a Roth IRA
  4. Disclaim all or part of the assets

For purposes of this article, we will only discuss these options generally, and will not go into detail regarding the advantages/disadvantages to these four options.  As you can see, the surviving spouse has several options to choose from.  He or she can use the funds if there is an immediate need, allow the assets to compound tax-deferred for future retirement needs, or disclaim to other beneficiaries for tax benefits. [Read more…]