When you have a loved one with a disability or functional needs, planning ahead and creating financial security for them is likely a top priority. How can you offer financial support without negatively affecting any means-tested government benefits they’re receiving or may receive in the future?
A special needs trust is one solid solution.
What is a special needs trust?
A special needs trust, also known as a supplemental needs trust, is an estate planning tool that enables a person with a disability or functional needs to hold assets and still receive Supplemental Security Income and/or Medicaid.
Because needs-based government benefits have income and asset limits, receiving financial gifts or assets could reduce or eliminate eligibility.
This means if you have an adult daughter with autism on SSI benefits and want to give her money to meet her living expenses, she could be disqualified from receiving needs-based government benefits. Likewise, if you die and leave her your Roth IRA worth hundreds of thousands of dollars or any amount that exceeds the asset limit, she could no longer receive SSI or Medicaid.
But if you put the assets into a special needs trust for your daughter, she can keep her benefits and receive your financial support for the rest of her life.
What can a special needs trust pay for? Money in a special needs trust is meant to be a supplemental resource, meaning it should cover expenses that aren’t already covered by government benefits. More specifically, the beneficiary should use the money for expenses other than food and shelter. You must ensure money is spent in accordance with IRS guidelines, so hold on to receipts or make a spreadsheet to keep track.
“You do have to account for how the money is spent any time in a year that you draw money out of it,” says Lisa Bamburg, a registered investment advisor and a founder and co-owner of Insurance Advantage and LMA Financial Services in Jacksonville, Arkansas.
Benefits of a special needs trust
Setting up a special needs trust for someone can help you enhance their quality of life and give you peace of mind. These trusts ensure that a person with functional needs will receive the financial support they need throughout their lifetime, whether you’re here or not.
Here are a few key benefits of special needs trusts:
Your loved one can still receive needs-based government benefits.
In some situations, creditors or lawsuit winners can’t access the funds or assets in the trust.
Trust funds can be invested by a trustee or financial advisor.
You may be able to have control over who inherits the trust when the beneficiary dies.
Trusts provide protection against financial abuse, as trustees have a fiduciary duty to act in the beneficiary’s best interest.
Types of special needs trusts
There are different types of special needs trusts, but third-party special needs trusts are typically more common. How you plan to fund the trust will determine which type is most suitable for your loved one.
Third-party special needs trust
This type of special needs trust is funded by someone other than the beneficiary, and it can be revocable or irrevocable. A real-life example would be the parent, grandparent or guardian opening and funding the trust.
Third-party special needs trusts aren’t only for individuals with disabilities; they can also be used for someone who struggles to manage their finances. According to Patrick Simasko, an elder law attorney and licensed insurance agent in Utica, Michigan, they can be used for an individual who is dealing with substance abuse, gambling addiction or anything else that might hinder them from managing their own money. In this case, the trust is called a spendthrift trust.
An advantage of a third-party special needs trust is you can appoint secondary beneficiaries to inherit the remaining funds when the original beneficiary dies.
There are two ways you can set up a third-party special needs trust:
Stand-alone trust: If you plan to financially support your loved one throughout your lifetime, and have other relatives or friends who may want to contribute as well, this may be the best option. It isn’t created as part of a will or trust, so the beneficiary can access funds before your death — this type of trust can be effective immediately.
Testamentary trust: This may be more suitable if you’re estate planning and want to leave the trust as an inheritance, but don’t want to give the beneficiary access to the trust immediately. Contrary to the stand-alone trust, this method creates the special needs trust under your will or trust, so it isn’t funded until you die.
First-party special needs trust
The difference between a first-party special needs trust and a third-party special needs trust is that the first-party version is funded with the beneficiary’s own assets. Thanks to a section in the 21st Century Cures Act, as of December 2016, if a person with functional needs is mentally capable, they can set up and fund their own first-party trust. Alternatively, a relative, guardian or court can set up the trust and fund it with the beneficiary’s assets.
Unlike third-party special needs trusts, a first-party version typically must have a Medicaid repayment provision. This means when a beneficiary dies, any remaining money goes to repaying Medicaid and if anything is left, it goes to listed beneficiaries. Also, in some states, the assets in the trust aren’t protected from creditors.
Still, a person with functional needs might choose this type of trust if they’ve received a windfall, such as a settlement for medical negligence or an inheritance. It may also be ideal for an individual who has existing assets, becomes disabled, but needs to qualify for means-tested benefits.
To qualify for a first-party special needs trust, the beneficiary must have a disability, be under age 65 when the trust is established, and the trust must be irrevocable.
As the name suggests, pooled trusts combine trusts for multiple beneficiaries and can be either first-party or third-party trusts. Pooled trusts are typically managed and invested as one, with subaccounts for each beneficiary.
Pooled trusts also have to be set up and managed by a nonprofit organization. The nonprofit acts as the trustee, administering funds, making investment decisions and meeting tax obligations. This convenience and oversight is often why people choose pooled trusts.
What happens to the funds in a pooled trust when the beneficiary dies? That often depends on the state you live in and whether it’s a first-party or third-party pooled trust.
First-party pooled trust: Depending on the state, the trust may keep some or all of the funds. Any remaining funds are required to go to Medicaid to reimburse costs. If there is anything left after that, it typically goes to designated beneficiaries.
Third-party pooled trust: Beneficiaries typically aren’t required to repay Medicaid. However, a portion of remaining funds may still go to the nonprofit.
How to set up a special needs trust
1. Think about your wishes for your loved one
This is one of the most important steps, as it determines how funds will be distributed. Think about:
How much money they need and how long it should last.
How frequently you want them to receive money.
How much you want them to receive.
What needs can be met with the money.
What will happen to any remaining money in the trust once they die.
Whether they will have control of assets.
2. Choose trustees
A trustee will help manage, invest and disburse funds for your loved one, so choose wisely. You can also choose contingent trustees, so you have a backup in case something happens to one. Once you select your trustees, you’ll have to sign the trust to transfer assets to the trustee.
Many people choose a trusted relative. While a lawyer or bank can serve as trustees, Simasko says you might want to consider the cost implications.
“Some lawyers will recommend you pick them to be a trustee or pick a bank to be the trustee and they will absolutely do the right job. But the fees will be so expensive that the bank will be one of the main beneficiaries of your estate, just because of the fees that they charge,” Simasko says.
3. Create your trust
While you can set up a special needs trust on your own, the wording used in the trust documents is important. The wrong wording can create issues that disqualify beneficiaries from receiving benefits. For this reason, Simasko suggests hiring a lawyer who specializes in special needs trusts or a special needs trust attorney to help you set it up.
Once you’ve drafted the trust based on your wishes for your loved one, all parties need to sign and it typically must be notarized. Don’t forget to register it with the IRS for tax purposes.
4. Fund it
After all parties have signed the trust documents, it’s time to fund your special needs trust. You can fund it with assets like cash, investments, life insurance policies that pay out when the policy owner dies. You can also designate property you want to hold in a special needs trust through your will, beneficiary designations on bank or brokerage accounts, or retirement plans.
Bear in mind that there is typically no minimum amount required to fund a special needs trust.
Funding a special needs trust may seem like an obvious step, but Simasko says it’s a step people often forget.
“If you spend all this money to create this beautiful trust but you don’t fund it, the trust is invalid because it doesn’t have any assets in it. You’ve got to fund the trust appropriately to make it work right.”
5. Invest your funds
How should you invest assets within a special needs trust? Bamburg suggests moderate investments so your loved one can access funds when the need arises. “You want to look at more of a moderate investment strategy. For example, you don’t want to use something like real estate that could be volatile.”
Also, some trust fund account providers have rules on what investments you can fund your trust with, Bamburg says, so check before choosing a provider.
Special needs trust fund fees and taxes
As with most trusts, you want to factor in taxes and fees before diving in. Speak to a financial advisor or lawyer for advice on how to minimize the costs. Generally speaking, it could cost several thousand dollars to set up a special needs trust — Bamburg says she paid around $4,000 to set up one for her son — and there may be ongoing fees as well, which will vary by financial institution.
The tax implications are also complex, so it would be wise to work with a tax advisor to plan ahead and create a strategy to reduce taxes if possible.