If a Special Needs person is named as beneficiary of an IRA, 401k, 403b or any other asset, that could ruin their ability to qualify as for SSI and Medicaid. However, paying retirement money to a traditional Third Party Supplemental Needs Trust can cause income tax problems. Accordingly, we usually recommend that the Supplemental Needs Trust be created with provisions that allow a slow withdrawal of the retirement account over the lifetime of the beneficiary into a trust for the following reasons:
- A traditional Third Party Supplemental Needs Trust can be named as a beneficiary of a retirement account, however, that is usually very tax inefficient from an income tax perspective as the IRS will require the retirement money to be paid to the trust within 5 years, and it will be taxed and the very high trust rates.
- To minimize income tax consequences, the trust should be designed as a modified IRA Stretch Trust.
- An IRA Stretch Trust requires the Trustee to withdraw a certain amount each year from the retirement accounts which name the trust as the beneficiary. The amount the Trustee is required to withdraw from the retirement account into the Supplemental Needs Trust is known as the Required Minimum Distribution (RMD) Amount. The Required Minimum Distribution Amount is a based upon a formula set by the IRS that is tied to the life expectancy of the beneficiary of the trust (the Special Needs person).
- By taking out only the RMD each year, the IRA can continue to grow tax deferred. After the trustee withdraws the RMD from the retirement account into the Third Party Supplemental Needs Trust, the trustee may leave the money in the trust or distribute it to the Special Needs person subject to the normal limits of Special Needs Trusts.
- PLANNING NOTE: This should never be set up as a Conduit Stretch Trust as that will ruin the benefits of the Special Needs Person. A Conduit Stretch Trust requires the RMD be distributed to the beneficiary every year.
- PLANNING NOTE: In order to establish the Special Needs Person's life as a measuring life for IRS tax purposes, and have the Third Party Supplemental Needs Trust be treated as an Accumulation Trust, upon the death of the Special Needs Person, the balance of the trust and the retirement money can ONLY be paid to a person who is younger than the Special Needs Person.
- PLANNING NOTE: If you think that the client may wish to benefit an older sibling of Special Needs Person, consider making that older sibling the measuring life.
One downside to naming a properly designed Third Party Special Needs Trust with accumulation provisions as the beneficiary of a retirement account is that the income tax rates for trusts is higher than that of an individual. However, if you wish to engage in special needs trust planning and provide a special needs person access to money from a retirement account, this appears to be one of the most tax efficient ways of doing so while also preserving the the government benefits of the special needs person.
It should be noted that when doing Special Needs Trust Planning, sometimes, if parents have more than one child, they will name name a non Special Needs child as beneficiary of retirement money and a trust for the Special Needs Child as beneficiary of other assets. This is a completely viable alternate type of plan, but care should be considered regarding what happens if that other child predeceases the parents.
