July 2022 — 

The MLO Minute: “Do I Need an IRA Special Needs Trust?” By Lesley Mehalick, J.D., LL.M., Supervising Partner of our Estates and Trusts Department, and Jillian Zacks, Esq., lead Estates and Trusts attorney in our Pittsburgh office — 

Deciding whether to name a Third-Party Funded Special Needs trust as the beneficiary of a traditional individual retirement account (IRA) has always been a conundrum for estate planners.  The decision is fraught with tax issues that continue after the owner of the IRA is deceased.  In years past, we would caution clients about leaving IRAs to special needs trusts.  Unless the trust was properly and carefully crafted to allow the life of the beneficiary to dictate the timing of the minimum required distributions after the death of the plan owner, the entire IRA would pay to the trust within five years.  This would cause a substantial income tax liability for the trust as IRAs and other qualified funds such as 403(b) and 401(k) accounts have deferred the payment of income tax until the distribution is paid to the beneficiary.  Often, unless the income is distributed to the beneficiary, the trust would pay the tax at a high rate of up to or over 37%. That is quite a substantial loss of assets intended to be used to supplement the life style of a person receiving means-tested benefits such as Medicaid, waiver funds and Supplemental Security Income (SSI).

With the passing of the Setting Every Community Up for Retirement Enhancement Act (SECURE Act) in 2019, the timing of minimum required distributions after the death of the plan owner changed.  Previously, a spouse could take the minimum required distributions over their lifetime as could any other individual person.  The SECURE Act now requires that individuals other than Eligible Designated Beneficiaries must withdraw the entire plan within 10 years.  Eligible Designated Beneficiaries include spouses, disabled and chronically ill individuals, minors (proposed regulations clarify up to age 21) and individuals who are not more than 10 years younger than the plan participant.  Eligible Designated Beneficiaries may still take the distributions over their lifetime.

How does carving out an exception for disabled individuals change special needs planning?  A Third-Party Funded Special Needs Trust, if it adheres to the requirements to qualify it as an accumulation trust, may receive the distributions from the IRA over the lifetime of the disabled beneficiary.  Practitioners must be careful because the requirements are strict and include:  the trust must be for the sole-benefit of the disabled beneficiary; the trust may not make payments to persons other than the disabled beneficiary during such beneficiary’s lifetime; the beneficiaries who will receive the assets after the death of the disabled beneficiary may not be a charitable organization; and, there cannot be payments to demand beneficiaries for lifetime gifting called Crummey powers.

How does creating a trust that adheres to these requirements help in planning for your family?  It may be that distributing the IRA to the Third-Party Special Needs Trust means less tax liability than distributing to a child in a high tax bracket.  It may be that your intent was always to name the Third-Party Funded Special Needs Trust as the beneficiary of your qualified funds and with a few changes it may now allow for the stretch of distributions over the lifetime of the disabled beneficiary.  But what if you are charitably inclined and now realize that naming a charity as a remainder beneficiary will not allow for the lifetime stretch?  You may want to utilize two special needs trusts.  One to accept the IRA that can be strictly drafted and one to serve the additional purpose of giving to charitable organizations or accepting lifetime gifts.

We recommend that you talk with your estate planner regarding these changes and find out if updating your trust or creating a new trust is optimal for you or your family.  We caution that even when a trust is drafted to accept the IRA, once funded the rules regarding distributions for the special needs of a beneficiary who receive means-tested benefits such as Medicaid or SSI may still make the income tax consequences of distributions from IRAs to the trust not ideal for your plan.  Coordinating your overall asset allocation with the needs of the beneficiary and other family members is important.