By Barry Jamieson, CFP®, MA
Ok, so you have established a Special Needs Trust (SNT) or you have plans to do so. You have been thinking about what assets will be used to fund the trust. Those plans include designating some of your 401K and IRA retirement funds to the trust, because much of your wealth is comprised of those assets. Although designating retirement assets may be the best way to fund the SNT for many, such a strategy also has its drawbacks. This article specifically addresses the tax and eligibility considerations when retirement assets are designated to the trust.
IRS Rules Affecting Distribution of Inherited IRAs
IRAs or 401Ks are often passed on to loved ones after one’s death. The beneficiary receives these assets upon death in the form of an inherited IRA (if acquired by a non-spouse beneficiary.) There are specific IRA tax rules that govern inherited IRAs, the details of which are complex and beyond the scope of this article. The main point behind these tax regulations is the policy that retirement assets need to be taxed at some point; they can’t be deferred from paying tax indefinitely. When a distribution is made from the IRA, it counts as taxable income. The length of time required before a person inheriting the IRA is obligated to make withdrawals depends on the age of the person receiving the asset, unless the beneficiary is the spouse of the decedent. When it is a trust or SNT that receives the IRA asset, the distribution rules are different than when the IRA asset is inherited by an individual. Often trusts are required to make distributions within 5 years of the death of the decedent, unless special language governing the trust is drafted.
Conduit versus Accumulation SNTs
A five-year mandated distribution from a trust could have considerable tax implications to the beneficiary. For SNTs, one way to avoid this short distribution period is to establish a “conduit SNT”, enabling distributions to occur over the life of the beneficiary. However, because this type of trust results in income to the individual with special needs, SSI and/or Medicaid benefits could be jeopardized. If the family is not counting on public assistance benefits for the individual, then conduit trusts could be beneficial, otherwise they are to be avoided in the family’s estate planning. The alternative to a conduit SNT is the accumulation SNT, which allows the required distributions to accumulate in the trust. Required minimum distributions are stretched over the life of the oldest trust beneficiary. Importantly, if the remainder beneficiary of the trust is a charity, then the IRA would need to be distributed within 5 years after the owner’s death, something that many families would want to avoid!
From the discussion above it should be clear that rules governing IRAs designated to SNTs are complex. Tax implications need to be carefully weighed against the risk of negatively affecting public assistance benefits. Depending on the goals of the individuals with special needs and other family members, it may be best to avoid designating IRAs to the SNT altogether. Given the complexity of these rules, it is recommended that families consult with a special needs estate planning lawyer and financial advisor in constructing an appropriate estate and financial plan.
References
1. McGuffey, David, L. “ Special Needs Trusts: Basics and Beyond”, February 2016. https://www.mcguffey.net/pdf/Special_Needs_Trusts_2016.pdf .
2. Special Needs Alliance, “Naming a Special Needs Trust as Beneficiary of your IRA or Retirement Plan”
August 2014, Vol. 8. Issue 5. https://www.specialneedsalliance.org/the-voice/naming-a-special-needs-trust-as-beneficiary-of-your-ira-or-retirement-plan/.
3. Jacobs, Deborah, L. “IRAs and Trusts: What You Need to Know, Forbes, September 2014.
https://www.forbes.com/sites/deborahljacobs/2014/09/04/iras-and-trusts-what-you-need-to-know/#4fc4298c172b.
4. Wilcenski, Edward, V. “Leaving Your IRA to A Disabled Person”, Forbes, May 2007.
https://www.forbes.com/2007/05/30/ira-disabilities-trusts-pf-estates-in_es_0530money_inl.html#2c968ee73ffb
