Should I leave My Retirement Assets to a Special Needs Trust?
Several months ago, this author examined the importance of beneficiary designations with respect to one’s retirement assets. The income tax treatment of annual required minimum distributions (RMDs) can be very different depending on whether one designates an individual or a trust as the primary beneficiary of one’s retirement plan.
This article expands on the prior discussion by addressing the situation of leaving one’s retirement assets to a Special Needs Trust (SNT) established for the plan participant’s disabled child. (For simplicity, this article will use the acronym “IRA” to mean any retirement plan which requires the beneficiary thereof to take annual RMDs).
When a trust, other than a SNT, is named as the beneficiary of an IRA, sound income tax planning would include a recommendation that the non-SNT contains a provision which requires the RMDs to paid outright to the trust’s income beneficiary or beneficiaries. This will allow the annual RMD to be taxed at individual income tax rates rather than at the trust’s more compressed income tax rates (indeed, trust income of slightly over $11,000.00 is taxed at the highest individual income tax rate).
However, when a SNT is named as the beneficiary of an IRA, such trust cannot require the payout of cash, as doing so would likely render the beneficiary ineligibility to receive public benefits which are resource and/or income dependent, such as SSI and Medical Assistance.
So, what are the options for a client whose estate includes significant IRA assets and who wants to leave assets upon his death to his disabled child?
- Asset Allocation: Sometimes a client can allocate assets in such a way so that only non-IRA assets are payable to a SNT. In the case of a client who has both a disabled child and one or more non-disabled children, and who has a significant amount of both retirement and non-retirement assets, the non-retirement assets alone can be distributed to the SNT for the disabled child and the non-disabled child or children can be named as the beneficiary(ies) of the retirement assets. This will result in the RMDs being taxed at the non-disabled child’s individual income tax rates.
Of course, not all clients will have enough assets to implement such a plan, especially when the goal is to equalize assets passing to each child.
Moreover, even clients who do have the “right” asset mix at the time of planning may later realize that the plan will not yield the intended result. For example, lets assume that plan participant, P, is 60 years old and has 2 children, one disabled and one non-disabled. P’s assets include a home worth $1M, a brokerage account worth $500K and an IRA worth $1.5M. P’s attorney sets up an estate plan with a Will that leaves the house and the brokerage account to the SNT established for the disabled child. The IRA names only the non-disabled child as the beneficiary. Now assume that P lives to the age of 95 years. P would have been taking RMDs from the IRA starting at age 701/2. By the time of P’s death, the IRA likely will not be worth an amount equal to the non-retirement assets which will then pass under P’s Will to the SNT for P’s disabled child.
A client may very well be satisfied knowing that his non-disabled child may wind up with less than one-half of the estate; however, a client must be made aware of this possible outcome during the estate planning phase.
- Name the SNT as an IRA Beneficiary
More often a client’s portfolio makes it impossible to equalize assets among his heirs without naming a SNT as an IRA beneficiary. In this case, as noted above, the RMD will be paid to the SNT but will not be distributed outright to the beneficiary. Rather, the RMD will be accumulated inside the trust. As a result, the RMD, which is deemed ordinary income, will be taxed at the very compressed trust tax rates.
- Cash out the IRA
A third option that a client might explore is to cash out his IRA during lifetime and pay the income taxes, thereby leaving the remaining cash to a SNT. Although this would remove the issues associated with naming a SNT as the beneficiary of an IRA, this option also negates the benefit of tax deferral which was the likely reason for initially establishing the IRA. However, based on a client’s overall financial position and income level (both current and anticipated income) a client may, with the guidance of his financial planner and/or accountant, determine that the income tax payment at individual rates at the time of the cash-out will make more financial sense than future income tax payments at the SNT’s rates.
In conclusion, a client whose estate plan includes providing for his disabled child must carefully weigh his options with respect to naming beneficiaries of his IRA assets. A client and his estate planning attorney should discuss these options in view of the client’s portfolio allocation (i.e. retirement vs. non-retirement assets), the anticipated changes over the client’s lifetime to such allocation and whether or not the client is determined to leave equal amounts of assets to all of his heirs. Consideration of these and other factors is essential to insure that a client achieves his overall estate plan.