How to Avoid and Minimize Taxes on Special Needs Trusts

Gifting investments, such as stocks, savings accounts, bonds, and mutual funds, is a smart way to fund a Third Party Special Needs Trust. These types of assets can grow over time and help the trust keep up with inflation, which is important for meeting the long-term needs of the person with special needs.

Despite their protective nature, a Special Needs Trust (SNT) is subject to complex tax rules that can erode trust assets if not properly managed. Minimizing income taxation is an essential component of SNT administration and long-term planning.

This article discusses key legal principles governing SNT taxation and lawful tax-reduction strategies consistent with the trustee’s duties, as well as government benefit regulations.

Tax Rules for Investment Gifts

When a donor gives an investment to a Third Party SNT, the value of the gift itself is not taxed. But once that investment starts generating money (like dividends, interest, or rental income), that additional money is considered income, which is taxable.

Depending on how the trust is set up, the income generated by the investment may be taxed to the trust, the beneficiary, or the settlor (the person who created the trust).

It’s important to plan how to legally minimize taxes on any new income the investment generates.

Generally, a federal income tax applies to trusts when the trust retains income – that is, when the trust does not distribute all of the income it earns to the beneficiary. When the trust retains income within the trust, the trust is responsible for paying the income tax on the retained income.

In most cases, it is best for the Trust to avoid income taxation because it faces steep tax rates very quickly. A trust will reach the highest tax rate brackets much more quickly than an individual. For example, in 2025, a single filer who earns an income of $626,350 or higher will hit the 37% income tax rate. On the other hand, a trust hits the 37% tax rate once it earns an income of $15,650 or higher. Due to the aggressive taxation on trusts, many families try to avoid income taxes being charged to the trust itself.

Here are three strategies to help reduce or avoid income taxes on investments held by a Third Party SNT:

1. Distribute Trust Income to the Beneficiary

An effective way to reduce taxes on an SNT is to distribute the trust’s income to the beneficiary, instead of keeping it in the trust. This doesn’t mean giving the beneficiary cash directly (as that would put their SSI and Medicaid benefits at risk). Instead, it means to use the trust income to pay for allowable expenses. Doing this makes the income taxable at the beneficiary’s tax rates, not the trust’s tax rates. This is ideal because the beneficiary is usually taxed at a much lower rate than the trust. Additionally, the trust can pay for the beneficiary’s taxes, which is an allowable expense.

Consider also the extra benefit of an individual’s standard deduction when distributing income to the beneficiary. In 2025, a beneficiary who is single and under 65 has a standard deduction of $15,750. The IRS lets taxpayers subtract the standard deduction from their total income from the year before calculating how much tax you owe. That means if the beneficiary’s total income is $15,750 or less, they won’t owe any federal income tax.

Example:

Mary’s SNT generates $10,000 in investment income for the year. The Trustee uses all of the $10,000 to pay for Mary’s allowable expenses. That $10,000 is counted as income (for tax purposes only) to Mary, not to the Trust. Since $10,000 is less than her $15,750 standard deduction, Mary pays $0 income tax on the distribution.

Even if the trust earns more than the standard deduction amount of $15,750, it can still be a good idea to distribute it to the beneficiary. This is because the beneficiary is usually in a much lower tax bracket than the trust. Using this strategy helps preserve more of the trust’s assets for the beneficiary’s long-term support.

2. Qualified Disability Trust

A Qualified Disability Trust is a special tax status that a Third Party SNT can qualify for under certain conditions. This status allows the trust to exempt $5,100 of income from federal taxes each year. Without this tax status, the trust is only allowed a $100 exemption, meaning more income would be taxed.

Recall that a federal income tax applies to a trust when the trust retains income. With a Qualified Disability Trust status, the trust can claim a deduction of $5,100 (in 2025). This means, the trust can retain up to $5,100 of income tax-free, which can then be reinvested or saved for future use – without being taxed at the high trust tax rate.

To qualify for this tax status, the trust must meet specific legal requirements. It must be irrevocable, it must be a Third Party SNT, it must be a non-grantor trust, the trust must established and operated for the sole benefit of a disabled beneficiary during their lifetime, and the trust must be established before the beneficiary turns 65.

Due to the complexity of establishing a Qualified Disability Trust status, it is best practice to consult with a qualified special needs planning attorney.

3. Intentionally Defective Settlor Trust

For some high-net-worth families, it may make sense for the settlor to pay the income taxes instead of the trust or the beneficiary. This strategy works best when the settlor’s income tax bracket is lower than the anticipated tax bracket of the beneficiary.

To use this strategy, the settlor agrees to be responsible for paying income tax on the income generated by the investments in the trust. This avoids tax for both the trust and the beneficiary. Setting up this type of structure within an SNT is called an “Intentionally Defective Settlor Trust.” (Although it is not defective at all, it actually is quite effective, contrary to the name.)

This strategy also removes the assets from the settlor’s estate and “freezes” their value, which is helpful to minimize the federal estate tax. However, the federal estate tax only applies to estates worth more than $13.99 million. So, this strategy is not necessary for every family.

Conclusion

Navigating the tax and benefits landscape of a Special Needs Trust is complex—but you don’t have to do it alone. With the right strategy, families can protect public benefits, reduce unnecessary taxation, and create a financial foundation that supports their loved one’s independence and quality of life for decades to come.

Our firm is dedicated to helping families design and manage Special Needs Trusts with clarity, compassion, and long-term vision. Whether you’re establishing a new trust, optimizing an existing one, or planning across multiple generations, we provide the legal guidance and personalized strategy you need to safeguard what matters most.

If you’d like a review of your trust, a tax-efficiency assessment, or help building a customized plan, we’d be honored to support you.

Your family’s peace of mind starts with a conversation - let’s begin it today.