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.

A Simple Way to Organize your Special Needs Planning Documents

If you are like most people, you didn’t assemble your special needs plan all at once.  You may have created a special needs trust in 2001, purchased life insurance to fund it in 2005, established a guardianship when your child turned 18 in 2008 and drafted a Memorandum of Intent last year.  Now all of the documents that make up your special needs plan reside in various envelopes “strategically” placed in different drawers or folders all over your house.  While this filing system may make perfect sense to you, it could be a nightmare for your loved ones if something happens to you.

It is very important for everyone, but especially for parents of children with special needs, to establish an organized system for conveying information about their special needs plan to the people who will be carrying it out.  The best way to do this is to create a special needs planning binder or file that contains, at the very least, the following key documents:

  • Your special needs trust, will, health care proxy and durable power of attorney, along with any other estate planning documents like irrevocable life insurance trusts or revocable trusts
  • Information about your home, including copies of the deed, mortgage(s), homeowners insurance and statements showing how to pay the utility, tax and mortgage bills
  • Court paperwork for a guardianships or conservatorships, especially your Letters of Appointment, accounts and any bond paperwork
  • A summary of your financial accounts including the bank/financial institution name, account type and account number
  • Copies of your retirement plan and confirmation of retirement plan beneficiaries
  • Life insurance policies and beneficiary designations
  • A Letter of Intent that gives instructions to your child’s caregiver
  • Information about your child’s public benefits, including SSI/SSDI award letters, Medicaid information and Section 8 determinations. just to name a few possibilities
  • A list of your child’s caregivers, their contact information and their roles
  • If your child is still in school, a copy of any Individualized Education Program (IEP)
  • A written medical history for your child and information about his doctors and medications and where to find them

Once you have created this binder, you need to make sure that your relatives or friends can find it easily, so don’t lock it in a safe deposit box that no one can access!

Housing Options for Adults with Special Needs

Fifty years ago, most people with even moderate special needs were institutionalized throughout their adult lives.  Now, thanks in part to societal changes and decades of litigation, most people with special needs, including those with very severe special needs, live in some type of community setting.  In fact, the U.S. Supreme Court has specifically ruled that people with special needs who receive government benefits must be housed in the least restrictive possible setting.  Here are some of the most popular housing options for adults with special needs.

Living with Parents or Other Family Members

Many adults with special needs, especially young adults, may live with their parents or other family members.  People with special needs who live with their parents don’t have to experience the sometimes stressful transition into a different type of housing when they become adults, and they are usually surrounded by caregivers (their family members) who have experience with their specific special needs.  In many cases, Medicaid funds can be used to pay family members who provide care for their children in their own homes.

But as any young adult will probably tell you at one point or another, living with one’s parents is not always a great solution.  In some cases, the child’s special needs will be more difficult than what the parents can handle.  In other cases, a child’s parents may be a bad influence on the child or may even abuse the child or steal his government benefits.  Depending on the person with special needs’ level of social interaction, he may not have the opportunity to meet a lot of other people if he is constantly surrounded by the same family members. Finally, as parents age, it may become impossible for them to care for their child anymore, and the transition from a life-long residence could be more traumatic for the child than if he had moved out when he was younger.

Section 8 Housing

The Section 8 program provides vouchers for people with low incomes to obtain housing in the community.  In general, a Section 8 recipient has to pay approximately one-third of her monthly income towards her rent, and the voucher pays for the rest.  Many people with special needs who receive Supplemental Security Income (SSI) or Social Security Disability Insurance (SSDI) benefits as their sole source of income will likely qualify for Section 8 as well.  In theory, Section 8 landlords must meet certain standards in order to rent their units to Section 8 tenants, but in reality, whether a unit meets these standards is rarely monitored closely.

Section 8 vouchers can allow people with mild or moderate special needs and low incomes to live on their own in the community.  However, it usually takes years to obtain a Section 8 voucher and, once acquired, there may not be any available Section 8 units for rent in the individual’s community.  Section 8 housing is also not appropriate for people with more complicated special needs who can’t live on their own.

Group Homes / Supportive Housing

Many people with special needs choose to live in supportive group homes with several other people with special needs.  Depending on the program, these homes could be staffed with counselors and other workers who help the residents live on their own, or, in some cases, the residents live without live-in assistance.  Group homes come in many varieties and can be paid for in many ways, including private payment or state programs for people with disabilities.

Group homes are great options for people with special needs who don’t require more advanced care but who cannot live independently.  In many cases, group homes also provide a social setting for the residents that they would not otherwise have if they lived with parents or on their own.

Assisted Living Facilities

Some people with special needs, especially older individuals, live in assisted living facilities.  Although the term “assisted living” has come to mean a lot of things, in general, assisted living facilities house residents in their own apartments within a building or complex of buildings.  The residents can cook in their units or eat in a communal dining hall, and they receive non-skilled care in their units, including assistance with bathing, cleaning and sometimes administration of medicine.  Some assisted living facilities specialize in treating people with dementia or other neurological conditions.

Skilled Nursing Facilities (Nursing Homes)

If a person with special needs requires around-the-clock skilled medical care, he may need to live in a skilled nursing facility if it is impossible to provide that care at home.  Although nursing homes are the last resort for most families, in some cases they can be the most appropriate option for a person with severe special needs because there is constant supervision of care and the person’s family members do not have to spend all of their time caring for their loved one.

Skilled nursing facilities are incredibly expensive, often costing more than $10,000 a month.  In many cases, an individual with severe special needs and minimal assets will qualify for Medicaid coverage that will pay for care in a skilled nursing facility.

Special Needs Trust Ownership of a Home / Payment of Rent

Special needs trusts can own homes for their beneficiaries or pay for a beneficiary’s rent in a private apartment.  In many cases, this is a very flexible option for the beneficiary, since the trust can also pay for services to help the beneficiary live independently.  However, home ownership by a trust comes with a large set of responsibilities.

Special Needs Planning Is a Marathon, Not a Sprint

Unlike some areas of law like “employment discrimination law” or “patent law,” special needs planning does not focus on one specific legal principle or topic. Instead, it encompasses a broad array of subjects that people with special needs and their families encounter, from estate planning to government benefits to guardianship to advocacy. Attorneys who focus on special needs planning have dedicated their practices to helping families with a wide variety of legal issues, and they must master a vast section of the legal canon in order to properly assist their clients. But all too often, clients arrive at the doorsteps of special needs planners with what they see as specific problems, and they believe that there will be a single, quick solution. Fortunately, good special needs planners don’t operate this way, because unlike some types of law that require a concentrated burst of effort to “solve” a particular problem, special needs planning is a marathon, not a sprint.

Of course, there are some times when clients need immediate solutions to very concrete problems, and special needs planners are happy to help. For instance, if someone is seriously injured in an accident and can no longer make decisions for himself, his family may need to pursue a guardianship right away, and this one step may consume significant time and energy, both by the family and by a special needs planner. That’s a sprint. But what happens once a family obtains guardianship? Do they no longer require special needs planning? Of course not!

  • The guardian will need assistance filing annual reports and accounts with the court, and this could go on for years.
  • If the injury came about because of someone else’s negligence, then the injured party may need a special needs trust to hold a personal injury settlement.
  • If he qualifies, he may need to apply for government disability benefits, including Supplemental Security Income, Social Security Disability Insurance or Medicaid.
  • Family members may have to change their own estate planning documents to make sure that they reflect their relative’s special needs.

No one needs to tell parents of young children with special needs that planning is a marathon (even though daily life may seem like one endless sprint). These families often come to special needs planners because they want to provide for their children if something happens to them, and this often leads to the creation of a special needs trust and a coordinated estate plan for the parents. As the child grows older and reaches the age of majority, he may need a guardianship if he is incapable of managing his own affairs. However, in many cases, the 18-year-old with special needs will be able to sign his own estate planning documents delegating the power to make health care decisions through a health care proxy and naming an attorney-in-fact to assist with financial affairs, and a special needs planner can help him do this. Housing, financial aid for college, and getting ready for independence all take years of planning, and the plans often change over time as an individual grows.

Special needs planners provide all of these services because their focus is on the long-term health and well-being of the client, not just on the immediate issues at hand. That’s why attorneys who focus on this area of law are called “planners.”

It can be frustrating to enter an attorney’s office with one problem only to realize that there is a lot more to think about (and probably worry about, at least initially) than you thought. But a good special needs planner will set your mind at ease and help you approach the future with confidence, and when emergencies strike (as they often do), your planner can jump to the rescue with the added benefit of having already gotten to know your family. If you’ve already started working with a special needs planner, make sure that you stay in touch. And if you’re just starting out, welcome to the marathon — your planner will be there every step of the way.

Should You Have a Care Committee in Your Special Needs Trust?

Most special needs trusts give their trustee wide authority, often appropriately so, to respond to unforeseen circumstances. But for those concerned about placing some checks and balances on the trustee’s authority, one possible option is a care committee.

Special needs trusts are trusts designed to protect the assets of a person with disabilities. The trustee is the person tasked with managing and distributing the trust’s assets on the beneficiaries’ behalf.

As previously discussed here, in addition to the trustee, many trusts create a separate care committee, either explicitly in the trust or through a separate memorandum of intent. Care committees, also commonly known as “trust advisory committees,” are typically granted the right to review accountings, to examine records, and to remove and replace the trustee.  To use an analogy from the corporate world, the trustee is the CEO and the care committee is the board of directors. The care committee may also be given the authority to amend the trust, veto certain distributions or participate in other decisions.

A downside to the creation of a care committee is that it can slow down the decision making process, at the expense of the beneficiary. Likewise, a care committee can deny the trustee the appropriate flexibility to act in the person with disability’s best interests.

To see if a care committee is right for your special needs trust, contact your special needs planner.

President Signs Special Needs Trust Fairness Act

The 21st Century Cures Act, which includes the Special Needs Trust Fairness Act has passed both the House and Senate and was signed by President Obama on December 13, 2016.  Individuals with disabilities, who have capacity, can create their own first party special needs trusts (sometimes called (d)(4)(A) trusts as they are established under 42 U.S.C. s. 1396p(d)(4)(A)). The federal statute prior to this legislation only allowed a special needs trust to be established for a person with a disability by the person’s parent, grandparent, guardian, or by a court.

The individual that would benefit the most from the trust, the beneficiary, however could not establish the trust themselves. The law as it was written presumed that all individuals with disabilities lack the mental capacity to establish a trust. The Special Needs Trust Fairness Act will end this presumption. No longer will individuals in need of a special needs trust, but without parents or grandparents, face undue legal difficulties.

The assets held within a special needs trust are considered to be non-countable for purposes of eligibility for means-tested public benefits, including Supplemental Security Income and Medicaid. The Special Needs Trust Fairness Act, along with the recent ABLE account, give individuals more options to managing their own financial affairs.

Please click here for our post on the Achieving a Better Life Experience Act, or ABLE account.

Legislation Would Add Option For Special Needs Planning

Parents of special needs children know how expensive education, therapies, rehabilitation and other medical costs can be.  When children transition into adulthood, adding in the costs of transportation, housing and other basic living necessities can be financially devastating.  Traditional planning for families included, among other things, special needs trusts to manage and distribute funds for special needs beneficiaries over their lifetimes.

The Achieving a Better Life Experience Act (ABLE Act) would allow parents and caregivers to put money into tax-deferred savings plans, like the 529 plans that parents use to save for college, to cover expenses like education, housing, transportation, therapy, rehabilitation and assistive technology. Advocates say the accounts, called 529-ABLE plans, would be easier and less expensive to set up and maintain than the trust funds often used for beneficiaries with disabilities.  As some government assistance programs only allow beneficiaries to keep $2,000, these new plans would allow a beneficiary funds to cover many services without jeopardizing programs like SSI and Medicaid.

Planning financially for a special needs child can be overwhelming.  Expanding the options for special needs families is critical.  To read the text of the bill and track the progress, click HERE.