Estate Planning: A Special Trust for a Special Need

Like many parents with a disabled child, Lisa Bamburg worried about how her son, Joel, who has severe autism, would survive when she was no longer alive to support him. Bamburg, co-owner of Insurance Advantage and LMA Financial Services in Jacksonville, Ark., knew that leaving money directly to Joel to provide for his care could jeopardize his ability to receive any help from means-tested government programs like Social Security's Supplemental Security Income and Medicaid. Typically, beneficiaries of either program can only have, at most, assets of a few thousand dollars, with the specific amount varying by state. That financial help isn't nearly enough to live on. "Joel receives $700 a month from SSI. If he didn't live with me, he couldn't make it on that," says Bamburg.

So 13 years ago, Bamburg set up a special needs trust for Joel, who is now 25. "The trust will provide for Joel when I'm no longer around to take care of him," she says. Because the SNT owns the assets instead of Joel, they are excluded from asset limit tests for SSI or Medicaid. Meanwhile, the trust can help fund quality-of-life improvements for the beneficiary, such as a phone, a trip or a private room in a group care facility. Medicaid typically only pays for a semiprivate room. The SNT is also a way to ensure that a vulnerable family member gets the money and that other relatives, such as the siblings of the disabled person, aren't left with the responsibility and cost of that care.

Interest in special needs trusts has been growing, says Kelly Piacenti, a chartered special needs consultant and head of MassMutual's SpecialCare program, which addresses the financial needs of people with disabilities. "In the past, people with serious disabilities often wouldn't outlive their parents. Now they're living full, rich lives." SNTs, however, come with specific rules for who can qualify for them and how the earnings are taxed, which can determine when these trusts are worth using.

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What Counts as a Special Need

A special needs trust can only be established for someone younger than age 65 and is meant for an individual with a physical or mental disability so severe that the person cannot work and needs ongoing support from Medicaid and Social Security. A disabled person who can still work could earn too much to receive government support, negating the need for this type of trust.

Bamburg notes that there's no national standard for regulating SNTs and every state has different guidelines for who can use one, with some requiring that a medical professional verify the trust beneficiary's disability. "For Joel, it was not easy," she says. "Even though we had school documentation of his disability and statements from his doctor, he still had to be tested by a third party he never met."

It's also not always possible to predict the severity of the disability over time. For example, a child with autism might improve enough to be able to work in adulthood. If you have no way of knowing, draw up the trust paperwork anyway, says Lindsay Graves, an elder law attorney and founding partner of The Graves Law Firm in North Canton, Ohio. "You can design a regular trust fund with a provision that if your family member qualifies for government disability benefits, it will then convert into an SNT." If the person doesn't need the special needs trust, it would still operate as an ordinary trust and give the beneficiary the income according to your instructions, but you may be paying for a more expensive trust than you need.

Financial and Legal Details

According to Piacenti, an SNT costs about $4,000 to $5,000 for an attorney to set up, whereas a simple trust starts at about $1,000. Plus, a trustee will need to be appointed to administer the trust. A family member can fill that role but not the special needs beneficiary.

SNTs must be drafted so that a beneficiary cannot have the ability to compel or direct distributions from the trust. "The trust terms should state explicitly that the trustee has sole discretion in making distributions for the benefit of the beneficiary," says Graves. Because every state has its own system for administering disability benefits, particularly for Medicaid, the trusts must also be tailored to match those rules. In fact, the SNT will need to be reported to the state. For instance, a trust beneficiary who applies for government benefits like Medicaid or Social Security's SSI will need to disclose the SNT's existence, but the person's ability to receive benefits won't be affected.

If a special needs trust beneficiary moves to a different state, the SNT may be subjected to two different sets of laws, and the trustee will want to confirm that the trust meets the new state's requirements. Most trusts are drafted to be controlled by the law of the state where they were created, says Graves. "The most likely outcome is that the administration of the trust would be governed by the state of origin, while the impact on the benefits would be governed by the state where the beneficiary is applying for benefits."

Once the trust is set up, the ongoing costs are reasonable. Bamburg pays less than $100 a year to maintain her special needs trust and serves as the trustee. A bank or a trust management company acting as the trustee usually charges 1% to 2% of the trust's assets each year in fees. There may also be accounting fees if a professional, rather than the trustee, prepares the trust's annual tax return.

Tax Treatments Aren't Always Favorable

SNTs operate as pass-through entities, and the tax treatment favors ongoing distributions to the beneficiary. Any earned investment income usually goes to the beneficiary that same year, with the distributions taxed at the beneficiary's income tax rate. Trust assets can help cover the tax bill.

As long as all the annual income is distributed in a given year, the trust won't owe any tax, but a return will need to be filed to report the income. For any undistributed annual investment income, the trust is taxed at one of four levels of tax rates, which are each much higher than those for individuals. For instance, the lowest income tax rate for a single person in 2022 is 10% for the first $10,275 in income. The trust, however, gets the benefit of that 10% rate only for the first $2,750 of income before the rate jumps to the next tier at 24%, and the highest trust tax rate -- 37% -- kicks in at just $13,451 of income. An individual isn't taxed at 37% until earnings top $539,900.

Most trusts that are set up in advance for a family member are third party trusts -- those funded by another person on behalf of the disabled individual. A first party special needs trust is typically created when a disabled person receives money directly, such as a cash settlement after an accident that caused the disability.

Although you could set up a first party SNT or fund an existing one, Piacenti recommends against it. "First party trusts usually include a payback provision. When to collect from any remaining trust assets to cover what the state paid in Medicaid benefits." A third party trust doesn't have that provision, she says, and lets you designate any remaining funds to another family member or a special needs charity.

The Retirement Savings Decision

The assets are transferred to the trust when it's funded, either at your death or during your lifetime. An SNT can be set up as a revocable trust, allowing you to reclaim the assets if they're needed. Cash, investment accounts, real estate or proceeds from a life insurance policy are common ways to fund the trust, but be careful about transferring a retirement savings account to an SNT. If you do so while you're alive, the amount transferred to the trust is considered a withdrawal. For pre-tax accounts like a 401(k) or traditional IRA, you would owe income tax on the entire account balance when it's used to fund the trust.

You could name an SNT as the beneficiary of your traditional retirement account when you die instead. The investments will continue growing tax-deferred as long as they remain in the retirement account. The trust will collect the required minimum distributions from the retirement account each year and pass the money on to the beneficiary as income. But, as with all of the trust's annual income, any undistributed amount of the required distribution, perhaps because it's more than the beneficiary can spend, is taxed at the trust's higher tax rate.

The Setting Every Community Up for Retirement Enhancement Act does give preferential treatment to a disabled family member who inherits a retirement savings account directly. Under the 2019 law, when most people inherit a retirement account, they must withdraw the entire balance within 10 years and pay the taxes. But heirs with a disability are permitted to spread those withdrawals over their entire lifetime, whether they are named as the account's direct beneficiary or an SNT is.

Of course, leaving the retirement account directly to a special needs heir would likely disqualify the person from getting Medicaid and Social Security assistance. You'll need to work with a financial adviser who understands the eligibility rules for government benefits and retirement taxes to determine which approach is best. "There's usually a clash between tax planning and benefits planning," Graves says. "You typically can only maximize one or the other."