If assets are left directly to a person with special needs, that gift could potentially impact the recipient's continued qualification for public assistance programs. On the other hand, placing the same funds in a special needs trust may allow the beneficiary to continue to receive such assistance.
Broadly speaking, there are three types of special needs trusts.
Third-party Special Needs Trust: Holds assets contributed by others who want to help the person with special needs.
First-party Special Needs Trust: Holds assets that become the property of a person with special needs as the result of an inheritance or perhaps a legal settlement from, for example, a medical malpractice or personal injury claim.
Pooled Trusts: Holds assets for the benefit of multiple beneficiaries with special needs.
The reason for the existence of differing types of special needs trusts is best understood within the context of the eligibility rules of public assistance programs, such as Supplemental Security Income (SSI) and Medicaid.
First-party Special Needs Trust
To qualify for certain federal and state assistance benefits, an individual must be considered legally disabled and have limited assets and income. This Trust is commonly created in situations where a special needs person inherits or acquires assets in their own name and as result is at risk for continued eligibility for public assistance. With these types of Trusts, the assets acquired by the special needs person are transferred into this Trust by or on behalf of the special needs individual. Prior to December 13, 2016, the trust had to be created by a parent, grandparent, guardian, or a court, but applicable federal law was modified so that a legally competent beneficiary can create such a trust for themselves and still use the trust as a means of protecting eligibility for federal and/or state public assistance. The requirement that the trust must be controlled by a trustee other than the special needs beneficiary remained unchanged.
The beneficiary of a first-party special needs trust must be under the age of 65 at the time the trust is created and have a physical or mental disability, or a chronic or acquired illness. While the beneficiary is alive, the trustee of the trust may make discretionary distributions from the trust to meet the beneficiary’s “supplemental needs,” such as education expenses, a vacation, or hobbies; but, generally, not for food or shelter, which would typically be provided for by Supplemental Security Income (SSI) or other public programs.
However, at the beneficiary’s death, the trust must provide that any assets remaining in the trust reimburse the federal and/or state agency for all benefits paid to the beneficiary during the trust term before the balance is distributed to other beneficiaries named in the trust - such as the family members of the special needs beneficiary. Please note that the federal government and each state have very specific guidelines for the use of assets in a first-party special needs trust. Failure to follow federal and/or state rules could disqualify the trust as a special needs trust as well as disqualify the beneficiary from assistance eligibility.
Third-party special needs trust
A third-party special needs trust serves the same function as its first-party counterpart in that it preserves the eligibility of a person with special needs for government benefits—but with 2 key differences. First, the third-party trust is typically funded by assets of parents or other family members of the person with special needs. This type of trust can be named as a beneficiary of an inheritance or a life insurance policy. Unlike first-party special needs trusts, there is no age restriction for the beneficiary.
Second, a third-party special needs trust does not include the “payback” provision to government agencies as required in first-party trusts. So when the beneficiary dies, any leftover trust assets don’t need to be used to reimburse the government; they can be passed on to other family members or to charity.
A pooled trust is a variation of a special needs trust that is usually operated by a charitable organization. Unlike a first-party special needs trust, this type of trust can be created by or for a beneficiary regardless of the individual’s age. However, if a beneficiary is 65 or older, some states impose a Medicaid transfer penalty on transfers of assets to a pooled trust. Pooled trusts enable beneficiaries to pool their resources for investment purposes while still maintaining separate accounts for each beneficiary’s needs. When a beneficiary dies, the funds remaining in their account are usually used to reimburse the government for the cost of care, but a portion goes to the nonprofit organization that manages the trust. Under certain circumstances, a state Medicaid program may not have to be repaid for its expenses as long as the funds are retained in trust for the benefit of other disabled beneficiaries (however, some states do require reimbursement under all circumstances).
This type of special needs trust terminates automatically when it’s no longer needed. Obviously, this can occur when the sole remaining beneficiary dies or the assets in the trust are depleted. However, if the beneficiary no longer either needs or qualifies for government benefits, and wishes to have the trust terminated, a court order would likely be required. Keep in mind that any termination of a first-party trust may trigger a payback to the state’s Medicaid agency for all Medicaid benefits paid to the beneficiary during the trust term.
These trusts are highly state specific. Each state has its own set of limitations and rules in terms of how funds may or may not be used. Proceeds may be taxed differently or not at all, and could affect eligibility for state-sponsored welfare or insurance programs. When creating a special needs trust, it’s important to work with an attorney to help ensure that the trust you choose will help meet your family’s needs.
In addition to the creation of a special needs trust as outlined above, another option would be to consider what is called an "ABLE" account, introduced by Congress in 2014. The ABLE (Achieving a Better Life Experience) account is designed to help working adults with disabilities as well as families caring for children or adults with disabilities. A key purpose of this plan is to help families save in the name of their special needs children without jeopardizing other critical financial benefits and programs that may be available to help their children.
What’s more, after-tax contributions to these accounts grow tax-deferred as long as withdrawals are used for qualified disability expenses.
Here’s how ABLE accounts work: Families can open an account for the benefit of a child with a disability who meets eligibility requirements or for a significantly disabled adult who experienced the onset of the disability before turning 26. Eligibility follows the guidelines and definitions for disability established by the Social Security Administration. In addition, a competent adult can open their own ABLE account if they are eligible and the onset of their disability occurred prior to turning the age of 26.
An ABLE account is in the name of the person with a disability and each such individual is limited to ownership of only one ABLE account. If the eligible individual is unable or unwilling to manage the account, a person with signature authority can open and manage the account for the benefit of the eligible individual. The person with signature authority must be the parent or legal guardian of the eligible individual or have power of attorney for the individual.
ABLE accounts are funded with after-tax contributions so there is no federal tax deduction for contributions. Contributions grow tax-deferred and withdrawals are free from federal and state income tax as long as they are used for qualified disability expenses, which may include rent, food, transportation, education, employment training, health care, and personal support services.
Anyone, including friends and family, can contribute to an ABLE account but the maximum annual contributions for tax year 2024 is $18,000. Additional funding for the account can also come from a disabled beneficiary who works and has employment income. A disabled person with employment income can contribute up to the $18,000 annually plus the lesser of 100% of their employment income or an amount equal to the federal poverty level as defined by the Department of Health and Human Services provided the employee and the employer did not contribute to a defined contribution plan. Up to $18,000 per year can be rolled from an existing 529 college savings plan account into an ABLE account, provided the beneficiary of the 529 account is either the beneficiary of the ABLE account or their family member.
There are a few limitations to consider as well. ABLE accounts with balances over $100,000 result in a suspension in federal Supplemental Security Income (SSI) benefits. If the ABLE account beneficiary dies, and he or she had received state provided Medicaid or health insurance benefits during the time the ABLE account was open, the state can make a claim for reimbursement from assets in the beneficiary’s ABLE account. Withdrawals to pay for nonqualified expenses are subject to federal and state income tax and a 10% penalty on the earnings.
If you are concerned with ensuring adequate support for your disabled child or loved one, consider whether establishing a special needs trust or ABLE account should be a component of your financial planning efforts.