Should Retirement Accounts Be Used to Fund a Special Needs Trust?

Families planning for a beneficiary with disabilities often confront a difficult balance: providing long-term financial support without jeopardizing eligibility for public benefits, such as Supplemental Security Income (SSI) and Medicaid. A Special Needs Trust (SNT) is a legal mechanism that holds assets for a disabled beneficiary, while also preserving access to to public benefits.

An increasingly common strategy is using retirement accounts—primarily IRAs and 401(k) plans—to fund an SNT. This approach can offer major benefits, but it also involves complex interactions among federal tax law, trust law, and public-benefits rules. Careful planning is essential to avoid unintended tax acceleration and consequences, loss of stretch distributions, or disqualification from SSI and Medicaid.

In this article, we will discuss using a retirement account to fund a Third Party Special Needs Trust, which is a type of SNT funded with assets (e.g., a retirement account) belonging to someone other than the beneficiary.

Many families use retirement accounts to fund an SNT because current federal laws provide a special tax advantage for a disabled beneficiary. Under the SECURE Act, most people who inherit a retirement account through a beneficiary designation must withdraw all the money within 10 years. In many cases, this is not a desirable result because it can create a large tax bill, and often the beneficiary would rather the money continue to grow in the retirement account.

The good news is that certain beneficiaries are allowed to spread or “stretch” the withdrawals out over their life expectancy, which lowers the tax impact. These special beneficiaries are called “eligible designated beneficiaries” and include:

-       the surviving spouse,

-       a person who is disabled or chronically ill, or

-       a person who is no more than 10 years younger than the original account holder.

This is great news for parents who are considering leaving their retirement account to their disabled child because the child can stretch out the retirement account withdrawals over their lifetime expectancy. Leaving the retirement account to a non-disabled child will not have this same benefit, a non-disabled child who inherits a retirement account will have to make withdrawals on the retirement account within 10 years, leading to greater tax losses.

(If no beneficiary is designated at all, then the money usually must be withdrawn within five years, depending on the age when the original account owner died. So be sure not to leave the beneficiary designation blank.)

Tax Treatment of Withdrawals from a Retirement Account

Most retirement accounts – except Roth IRAs – are funded with pre-tax dollars. This

means any money withdrawn from the account is taxable income, because it has not yet been taxed.

The faster the account is emptied, the higher the taxes, because the yearly withdrawals are larger. Stretching out the withdrawals over a lifetime keeps the yearly tax burden lower and allows the account to keep growing tax-deferred.

Example: Using the Right Beneficiary for a Retirement Account

Suppose a parent has two children, Jack and Jill. Jack has a disability, Jill does not. To keep things simple, suppose the parent owns a $500,000 life insurance policy and a $500,000 traditional IRA. Let's consider two different options:

Option (A): The parent leaves the life insurance to Jack’s SNT, and the IRA to Jill.

Result:

• Jack's SNT will pay $0 in taxes on the life insurance.

• Jill is not disabled. She must withdraw the IRA over 10 years = $50,000/year.

• Jill is in the 32% income tax bracket = $16,000/year in taxes.

• Over 10 years = $160,000 total taxes on the retirement account.

Total Amount of Taxes Owed by the Siblings = $160,000.

Option (B): The parent leaves the IRA to Jack’s SNT, and the life insurance to Jill.

Result:

• Jack is disabled. He qualifies to stretch out the withdrawals over his lifetime.

• Suppose Jack’s life expectancy at this time is 36.2 years, so withdrawals =

  $13,812/year, which are all pushed out of the SNT to pay for Jack’s expenses.

• The withdrawals are less than the standard deduction = $0 each year in taxes.

• Over Jack’s life = $0 total taxes on the retirement account.

• Jill pays $0 in taxes on the life insurance.

Total Amount of Taxes Owed by the Siblings = $0.

Choosing the right beneficiary for a retirement account can protect benefits and create huge tax savings, helping families keep more money in their children’s hands and less money eaten up by taxes. By using Option (B), Jack receives his parent's retirement distribution through the SNT each month, and the family saves $160,000 in taxes. This is the power of planning.

How To Use This Strategy

Step 1: Create a Third Party Special Needs Trust.

There are strict legal requirements that an SNT must meet in order to be a valid beneficiary of a retirement account for compliance with the IRS. To qualify, the trust must have “see-through” status. This means the trust must be valid under state law, it must be irrevocable at the account owner’s death, the beneficiaries must be identifiable, and a copy of the trust must be provided to the plan administrator by the required deadline.

There are other legal requirements that an SNT must meet for compliance with SSI and Medicaid programs. To preserve these public benefits, the Special Needs Trust must be an “accumulation” trust and not a “conduit trust.” As an accumulation trust, the trustee must have the power to accumulate the distributions from the retirement account within the SNT. If the trustee is required to distribute the funds received from the retirement account, such as is the case with a conduit trust, the child’s SSI benefit will be reduced or eliminated altogether. 

If parents want to use their retirement account to fund an SNT, it is essential to work with an attorney to ensure everything is done properly.

Step 2: Name the Special Needs Trust as the Beneficiary of the Retirement Account

Make sure the disabled child is not named directly as the beneficiary of the retirement account. Instead, the Third-Party Special Needs Trust should be named as the beneficiary.

Key Takeaway:

Under the current law, using retirement accounts to fund a Special Needs Trust can be a great strategy to provide long-term financial security for a disabled beneficiary. This strategy can protect the beneficiary’s public benefits and take advantage of tax savings that are designed specifically for those who are disabled.

Families considering this strategy should work closely with an attorney, because the details are complex and the consequences are significant.