Avoiding Mistakes When Funding a Special Needs Trust
by Don Drake, Connelly Law Offices, Ltd.
"We continue our focus on October as National Special Needs Law Month. Just to review, special needs planning can involve special needs trusts, care management, advocacy to preserve educational or civil rights, public benefits such as Supplemental Security Income (SSI) and Medicaid, and many other critical issues affecting families and those with special needs," said certified elder law Attorney RJ Connelly III. "In our blog today, I want to concentrate on funding special needs trusts (SNT). It's crucial to properly fund an SNT, designating the trust as the owner of certain assets. This allows the trustee to distribute these assets to benefit the disabled loved one."
But what needs to be done to fund these trusts properly? "First, you must choose the type of trust that best suits the situation for the special needs child or adult," said Attorney Connelly. "Retaining an experienced and knowledgeable special needs attorney is critical to carefully select a first- or third-party SNT based on maximizing available government program benefits and assessing future tax implications." Let's look further at these options.
Making the Trust the Legal Entity
In many instances, the first step to funding a special needs trust is establishing a taxpayer ID number from the IRS. This is a straightforward process that can usually be accomplished within twenty-four hours. Once set up, the trust is irrevocable. "An exception to the EIN requirement is establishing a living trust and will, which becomes irrevocable upon the trust creator’s death requiring an EIN later. This nine-digit Employer Identification Number (EIN) acts like a social security number for the trust so that the IRS can identify the trust as a separate legal entity," stated Attorney Connelly.
How to Fund the Trust
"Funding options for an SNT are unique to each family situation," stated Attorney Connelly. "For instance, money from a personal injury settlement can fund a first-party SNT trust (if the individual is under 65 years old), and any inheritance the beneficiary receives directly. However, upon the death of the disabled individual, these trusts do have pay-back provisions for Medicaid."
A third-party special needs trust is written either during the creator’s lifetime, known as inter vivos, or as a testamentary trust accessed upon the creator’s death. "The inter vivos trust allows other family members or friends to contribute to the trust before the trust creator’s death," pointed out Attorney Connelly. "In most cases, third-party SNT funding includes inheritances, family savings, and other financial gifts, which can be invested in stocks or bonds for the growth of the trust as a hedge against inflation. The SNT trust can be self-sustaining as long as there are appropriate financial decisions being made."
There are also other ways a family can create an SNT third-party trust and ways to fund them. Let's explore these possibilities.
Life Insurance Policies There are several products to consider before making your choice.
Survivorship or second-to-die life insurance policies can be a good funding choice as they tend to have less expensive premiums; but, as the title of the product indicates, they will not pay out until the second member of a couple dies. "Domestic partners may also purchase coverage as you do not have to be legally married to buy a policy," stated Attorney Connelly. "There may be problems if the remaining spouse or partner does not have enough finances to cover the family’s ongoing expenses from other sources." A survivorship insurance policy requires a close look at your retirement planning and other income sources, as well as funding a special needs trust.
Term life insurance is often another inexpensive funding choice for a special needs trust. "Term life insurance policies guarantee payouts during a period that is specified and are typically inexpensive," pointed out Attorney Connelly. "These policies can be renewed when they expire, as long as there are no significant changes in health. However, renewing these types of policies mean higher premiums as you get older and if you have declining health."
"Whole life insurance covers your entire life span and the premiums you pay collect in an investment account that the insurance company invests in to grow value in the policy," stated Attorney Connelly. "The premium costs of these policies are fixed."
"Variable life insurance will provide lifelong coverage," said Attorney Connelly. "But the policy cash value is subject to changes in the financial market, which could be risky."
Real Estate "For a person with special needs, the family home represents stability and routine, and staying in that residence may be an important goal for continuity and long-term well-being," states Attorney Connelly. "But leaving the house in the name of a special needs loved one can be a huge mistake as it affects means-tested government benefits. There are options, however, as real estate in a third-party SNT will avert the Medicaid lien of a first-party trust upon their death and transfer to other beneficiaries instead."
If the special needs individual needs to move and sell the home, the sale proceeds will remain in the trust. If moving is not contingent upon selling the house, the SNT trustee can convert the property to a rental, producing income for the trust. In either case, it is essential to have adequate trust funds to maintain a family home in the SNT.
Retirement Plans "To be clear, funding an SNT using a retirement plan is fraught with complexities," points out Attorney Connelly. "Such funding takes careful financial management, all the funds distributed to the trust’s beneficiary may be taxed during the transfer year. This situation could result in eligibility disqualification for government benefits and unnecessarily high taxes."
There is an exception, however, and that's designating military survivor benefits to a special needs trust recently adopted through the Disabled Military Child Protection Act federal legislation. "There is a caveat, if the special needs trust receives funding from non-military retirement accounts, the SNT should be an 'accumulation trust,' which spaces out required minimum distributions," said Attorney Connelly. " In addition, any remainder beneficiaries (those entitled to remaining funds upon the death of the primary beneficiary) should ideally be younger than the primary beneficiary to avoid unintended distribution requirements."
"It's important to remember that retirement accounts can negatively affect the intent of the special needs trust," continued Attorney Connelly. "We may encourage draw downs on the retirement account so as to purchase life insurance for the SNT or leave their retirement funds to other heirs. As I stated earlier, using retirement money for an SNT is quite complex."
"Remember one thing, the reason for an SNT is to protect all future government benefits for the individual who needs them. Making a mistake when setting up an SNT could be disastrous so using a professional with knowledge and experience is the best choice a person could make in this situation," concluded Attorney Connelly.