These unique legal instruments can provide many benefits to disabled persons with their tax advantages and other features that can provide peace of mind
If you are the parent or caregiver for a child or loved one who is disabled, then the cost of supporting them can be a major financial burden. Of course, government programs and public benefits are available for those who qualify, but there is a stipulation that the disabled beneficiary cannot own more than $2,000 of personal assets, including bank accounts, retirement accounts and certain items of personal property.
This limitation can make it extremely difficult for the beneficiary to function effectively-and the benefits that are paid might not be enough to cover all of the beneficiary’s necessary living expenses. Fortunately, there is a legal instrument that can greatly aid those who face this dilemma. Special needs trusts were created in order to provide disabled persons and their families some financial relief.
The first thing you need to know when it comes to understanding what a special needs trust is what exactly what constitutes a trust in a generic sense. Trusts are separate legal entities that are created and funded by a donor. The donor or donors then appoint a trustee or trustees to manage the assets in the trust for the benefit of the beneficiaries. Trusts can buy, sell and own property and will usually continue to exist after the donor or donors are gone.
The trustee is bound by fiduciary law to manage the trust assets according to the wishes of the donors, which are spelled out in the original trust document. There are many different types of trusts, such as living trusts, testamentary trusts, springing trusts, pourover trusts and irrevocable trusts. Special needs trusts are usually irrevocable (see exception below), and its assets cannot be seized by creditors if the donor or trustee declares bankruptcy or loses a lawsuit.
A special needs trust is an estate planning tool that allows you to leave assets to your disabled beneficiary without endangering their eligibility for governmental benefits such as Social Security Income, Supplemental Security Income, Medicaid or other benefits. When you die, the assets that you wish to bequeath to your disabled beneficiary will be placed inside the trust. When you set up this kind of trust, you’ll need to appoint a reliable trustee to oversee the management of the trust after you’re gone. The trustee will have complete control of the trust after you’re gone (within the scope of your wishes) and will pay out benefits for supplemental needs on behalf of the disabled beneficiary at his or her discretion.
The funds in the trust cannot be paid directly to the beneficiary, as this could disrupt his or her eligibility to receive SSI payments. But trust funds can be used to pay for expenses incurred by the beneficiary, including living expenses, health care costs, transportation, personal care, various forms of therapy and any devices or equipment that are needed. The trust will continue to exist either for as long as the beneficiary lives or until all of the assets in the trust are exhausted. There are three main types of special needs trusts: “first-party” trusts, “third-party” trusts and pooled income trusts.
First-party special needs trusts usually designed to hold assets that are paid directly to the disabled beneficiary, such as an inheritance or the proceeds from an accident or personal injury settlement. This type of trust can also be established using assets currently owned by the beneficiary. Beneficiaries must be under the age of 65 in order to establish this type of trust. Disabled persons who place these assets into a first-party trust can remain eligible to receive Supplemental Security Income (SSI) payments, because the beneficiary has no control over the assets in the trust.
Because of this, the government does not consider these assets to be owned by the beneficiary. The money in the trust is used to pay the expenses of the beneficiary as long as he or she is living, and any remaining proceeds in the trust are then used to repay the government for its SSI payments after the beneficiary dies.
This type of trust is generally the most effective when the beneficiary comes into a large sum of money, such as a sizable inheritance or a multimillion dollar settlement from a legal or insurance claim. First-party trusts are also commonly referred to as self-settled SNTs, Medicaid payback trusts, OBRA ’93 trusts, and d4A or d4C trusts. Current law now also allows these trusts to be established by the beneficiary, provided that they are legally and mentally competent. But the trust funds held inside first-party trusts are generally subject to seizure by creditors of the beneficiary.
This type of trust is generally established by friends or family members of someone with special needs who want to fund the trust with some of their own assets. Third-party trusts can hold virtually any type of asset under the sun, including cash, real estate, securities or other types of investments. These trusts resemble their first-party cousins in that placing assets into them effectively shields the beneficiary from losing their SSI payments.
But they differ in that there is no payback clause after the death of the beneficiary. Any remaining assets can be dispersed to the secondary beneficiaries of the trust or to charity. Donors can therefore effectively provide for the needs of the beneficiary while he or she is living, then dictate where any remaining assets will go after the beneficiary dies.
Third-party trusts can be contained in a Last Will and Testament, in a revocable living trust or stand alone by themselves. Standalone trusts are generally more appropriate when more than one donor wants to contribute to the trust, whereas the other two alternatives will not spring to life until the death of the donor.
Third-party trusts do not need to be irrevocable in nature in order for the beneficiary to retain eligibility for SSI. But if the beneficiary him or herself is given the power to revoke the trust, then the assets in the trust will be counted as assets owned by the beneficiary.
Pooled Income Trusts
Pooled income trusts are structured as either first or third-party trusts, but they are fundamentally different in nature from either type of trust. These trusts are established by charities or other nonprofit groups and hold the assets of many different beneficiaries. The monies that are placed inside them are then pooled into a group of investment offerings, and each beneficiary retains a separate account and receives a pro-rata share of the investment income generated by the trust. In many cases, the beneficiaries will work with a social worker or other fiduciary advisor to craft a financial plan that meets the beneficiary’s needs.
Pooled trusts are like first and third-party trusts in that they allow the beneficiary to continue receiving SSI payments, and they allow the beneficiaries to transfer as many of their assets as necessary into the trust without needing help from a friend or family member. These trusts are also like first-party trusts in that there is a payback clause built into them that reimburses the government for all SSI payments made from the date the trust was used until the death of the beneficiary. But the government will often allow the charity that was used to retain a percentage of the remaining trust assets as a means to further their cause.
Pooled income trusts are often appropriate for disabled beneficiaries who only have a relatively small sum to invest, because of their lower costs. Some beneficiaries also look favorably on these trusts because it allows them to pay non-profit organizations to help others with special needs. The Academy of Special Needs Planners has a directory of pooled income trusts that you can refer to if this type of trust appeals to you.
Some states will allow beneficiaries who are age 65 and above to establish pooled first-party trusts, but many states assess a penalty on those who do so. And if the beneficiary (regardless of age) is determined to be mentally incompetent, then a court must approve any decision to fund the pooled income trust with the beneficiary’s own assets.
Disadvantages of Special Needs Trusts
Some of the disadvantages of special needs trusts have already been covered, such as the payback clause that exists in first-party trusts. Another disadvantage is that the beneficiary has no power over the management of the trust assets and must continually request the trustee to pay for his or her expenses. Special needs trusts can also be very expensive to establish, and the annual costs of maintaining this type of trust can also be steep. There may also be a minimum amount required to establish a SNT in many cases.
Finding the Right Trustee
This is one of the most important elements that must be addressed when establishing a special needs trust. The trustee on this type of trust will have all of the power once you’re gone, so choose your trustee carefully and make sure that he or she has the best interests of your beneficiary at heart. Your trustee will not be required to pay for every expense requested by your beneficiary, but will only need to follow the parameters that you set up in the trust. You may want to use a professional trustee, such as a lawyer or financial planner, or at least name that person as a co-trustee along with one of your relatives in order to ensure that the trust is managed competently and according to your wishes.
The tax rules that pertain to special needs trusts can be quite complex in many cases. Even if the beneficiary received a tax-free lump-sum settlement, there may still be income taxes to pay later on, because the investment income that is generated by the settlement amount will be counted as taxable income in most instances, assuming that a first-party trust is used. The tax rules for third-party trusts are much worse. These trusts are taxed directly, which means that they have to pay taxes at trust tax rates, which are astronomically high. The trust can deduct the amount of all payments made on behalf of the trust beneficiary, but the beneficiary will then have to pay tax on this income at his or her top marginal tax rate.
This only scratches the surface of the tax rules that govern special needs trusts. In most cases, you will need to consult with your tax or financial advisor in order to learn all of the subtleties related to reporting this income correctly.
Special needs trusts can be instrumental in allowing disabled beneficiaries to continue receiving SSI and other government benefits without having to deplete all of their assets. But there are many state-specific rules that must be followed, as well as federal guidelines. It is usually wise to at least consult with an estate planning attorney who specializes in this area for legal advice, as well as a tax advisor. Consult your financial planner for more information on these trusts and how they can work for you.