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Leaving your IRA to a Special Needs Trust requires some finesse

Now that he has navigated Halloween successfully—his costume received lots of complements and he picked up enough candy to hold him until Easter--my son has turned his efforts towards the all-consuming late-fall work of childhood—creating one’s holiday gift list. Instead of eating his cereal this morning, my son was scrolling through a website called Vat19, a website that sells weird and quirky items, such as a “Turbospoke Bicycle Exhaust” attachment that “Makes your bike look and sound like a motorcycle”, the “Sheet Storm”, a nerf-like gun that uses a mounted roll of toilet paper and water to fire spitballs, an air “freshener” that smells like farts, a “Burrito Blanket” that looks like a giant tortilla, and “Pyro-mini”, a wrist-mounted miniature flamethrower. To quote the respected Dave Barry “I am not making this up!”.

I’m not sure which worries me more—that the items will work as promised and wreak havoc on our home or that they will work so poorly as to be a total waste of money. But boring adult reasoning will not deter my son. And, to get beyond the paralyzing prospect of having to choose actively among these incredible items, my son has decided to request a “Mysterious Box of Mystery”, which (in case the name didn’t clue you in) is a “Surprise selection of curated Vat 19 goodies”. Yes, mysteries and surprises are sometimes great for gifts; but almost never for estate planning and certainly never for special needs planning.

For many households, retirement assets such as 401(k)s, 403(b)s, and IRAs represent the majority of the family’s resources. You, as parents, expect that some of this “qualified” money will find its way to your heirs. If you have a child, minor, or adult, and with a disability, you are aware that a sudden inheritance could disqualify them from receiving means-tested benefits such as Supplemental Security Income (SSI) and Medicaid, which funds most adult services through Medicaid Waivers. To avoid this, you have created a Special Needs Trust and have listed the Trust as the recipient of that child’s share of her/his inheritance. You should definitely give yourself credit for taking these concrete steps. But while listing your child’s Special Needs Trust as the beneficiary of your retirement assets resolves an important issue in benefits planning, you still need to consider the tax implication of leaving retirement assets to a trust.

The IRS rules that govern how fast one has to withdraw assets from a qualified account like an IRA depend largely on two things. The first is whether or not the original owner was over 70-½ and had thus begun to take her/his required minimum distributions (RMDs). The second is who or what is the beneficiary and how that person (entity) is related to the original owner. In general, if the original owner has already started to take RMDs, then the beneficiary continues to take the withdrawals over the original owner’s remaining life expectancy. The exception to this is a spousal beneficiary, who can roll the assets into her/his own IRA and delay any further withdrawals until s/he is 70-½. Also in general, if the original owner had NOT begun to take RMDs, a non-spousal beneficiary must then begin to take distributions over her/his own life expectancy. This has the effect of “stretching” the distributions. If the IRA is left to more than one beneficiary, it can be divided so that each beneficiary can use her/his own life expectancy, giving some additional stretch to younger beneficiaries. If the account is not split by the end of the year following the year of the original owner’s death, then all beneficiaries must use the life expectancy of the oldest.

In all the above cases, the beneficiary is a human, or what is called a “natural person”. One can also leave an IRA to an entity designated a “legal person”, such as a charity, estate or trust. If the original owner lived to or beyond April of the year following her/his attaining the age of 70-1/2, then the entity can take distributions, based on the original owner’s life expectancy. If not—and here is the big difference between natural person and legal person beneficiaries—the entity must distribute the entire value of the account within five years. If the entity is a charity, the tax impact is nil, because charities don’t pay tax. But what if the entity is a trust?

When the beneficiary of an IRA is a trust, the IRS will use four tests to determine whether the trust may be considered a “see-through” or “look-through” trust. If 1) the trust is valid under state laws, 2) the trust is irrevocable or becomes irrevocable at the original IRA owner’s death, 3) the trust’s underling beneficiaries are all identifiable as human, natural persons (so no other trusts, estates or charities), and 4) the trust documentation is provided to the IRS by October 31st of the year, following the year of the IRA owner’s death, then the IRS does not consider the trust as an intermediary, but rather “looks through” the trust to see who are the actual persons benefiting.

Thus, if you expect your child’s special-needs trust to be the beneficiary of any IRA accounts, you need to carefully consider the beneficiary structure of the trust. If your child with special needs is the only beneficiary, then the situation is simple and the IRS will expect IRA distributions just as if your child had been the direct beneficiary, but the trust as intermediary will still protect the child’s eligibility for means-tested benefits. The only drawback is that the distributions, taxed as ordinary income, would be taxed at trust rates, which get quite high quite quickly. If the RMDs are distributed to the beneficiary as they are removed, they would be taxed at the beneficiary’s income tax rate BUT they would also count as income to the beneficiary and might disrupt public benefits.

If there is more than one individual beneficiary to the special needs trust, things become more complicated. For instance, suppose you have two children with disabilities, but you use one special-needs trust to hold both of their assets. Or suppose that your only child with special needs is the primary beneficiary of the trust, but an older sibling or other relative is a contingent beneficiary. Now, you run the risk that the IRA distribution will be based on the shortest life expectancy among all the beneficiaries. Given the you don’t want to distribute too much income to the beneficiary with special needs, and given that distributions that are not distributed must pay tax at the trust rate, this situation will force the faster payment of higher taxes. It gets even dicier if you want the non-profit that has supported your child in life to be a remainderman of the Special Needs Trust when your child dies. If, you have a non-natural “legal” person as a beneficiary, the trust will fail the “see through” test.

Personally, I consider it a risky proposition to request a “Mysterious Box of Mystery” as one’s main holiday gift. I doubt I will convince my son of this risk. The worst-case scenario for him is that he will be disappointed in the gift, but at least he gets a “do over” next year. There are no do-overs in special-needs planning, however. If you want or need to leave your IRAs to your special-needs trust, make sure that your financial planner, tax advisor, and attorney help you to thoroughly understand the impact of doing so on both your child’s eligibility for public benefit and the rate at which income the IRA assets will must be withdrawn and taxed.

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