In the most recent issue of The Voice, Tara Pleat and Ed Wilcenski described the various types of retirement plans and discussed how these plans affect eligibility for means tested public benefits , primarily Supplemental Security Income (SSI) and Medicaid. In this issue, we will discuss the planning options available to retirement account owners, primarily parents, to shelter these assets for their children who receive means tested benefits.
Retirement assets increasingly make up a significant portion of many individuals’ wealth. With fewer employers offering a defined pension benefit (payments of a specific monthly sum to the retired worker), most retirement nest eggs now consist of 401(k) or 403(b) plans and IRAs. When passing these assets on to their children through their estate plans, parents and their lawyers must contend with the convergence of several competing interests, including public benefits issues, taxes and charitable intent. A recent article (by fellow Alliance member Ed Wilcenski) on Forbes.com  describes some of the complexity.
It is important to remember that retirement benefits are not controlled by your will. Rather, their disposition is controlled by the beneficiary form you filled out in association with the retirement plan. For example, if your will states that you leave all your assets to Neal, but your IRA beneficiary form names Emily as beneficiary, Emily will receive your retirement assets.
We often see situations where parents have created wills and a special needs trust for their child with a disability but have neglected to revise their beneficiary designations so that the child’s share goes to a special needs trust. It is not uncommon to see a situation where a parent has designated his spouse as primary beneficiary of his retirement plan and his three children as contingent beneficiaries. If one of those children is receiving public benefits, the parent has created a significant and unnecessary problem that can easily be avoided.
SSI and Medicaid have asset and income limitations. Leaving retirement funds directly to a person receiving these benefits will almost always disqualify the beneficiary from receiving SSI and Medicaid.
Most retirement funds consist of tax deferred assets. Generally, the employee receives a deduction for contributions made to the retirement fund. However, when distributions are made from the funds, they are taxed at ordinary income tax rates.
Roth IRAs consist of previously taxed assets, and distributions come out tax-free.
The Internal Revenue Code requires mandatory distributions from retirement funds when the owner reaches 70½ years of age. A person can choose to begin receiving distributions without penalty at age 59½.
When the owner of a retirement plan dies, special rules mandate at what rate an inherited retirement account must be paid out to the beneficiary. These complicated rules about inherited retirement plans make planning with them particularly challenging when the beneficiary receives means tested public benefits. These include:
- Retirement funds left directly to an individual may be stretched out over the beneficiary’s life expectancy to preserve some of the income tax benefits offered by the retirement account. This is attractive from an income tax perspective, but this is not an option for a beneficiary receiving means tested benefits because direct receipt of the funds will usually disqualify the person from receiving benefits.
- If retirement funds are left to a trust for the benefit of a beneficiary, the favorable tax treatment can be preserved if the trust provides that all of the retirement account’s annual required minimum distribution is to be paid out to the beneficiary each year. Such a trust is sometimes referred to as a “conduit trust.” Unfortunately, a conduit trust will not preserve eligibility for means tested benefits because of the mandatory distributions to the beneficiary.
- Because a special needs trust is a discretionary trust, not a conduit trust, another subset of rules applies, the most important of which is that the age of the oldest beneficiary, either the special needs beneficiary or any contingent beneficiary, will be the measuring life for determining the rate at which retirement funds must be distributed to the trust and, therefore, taxed.
For instance, assume that Jack is the primary beneficiary of a special needs trust that is the beneficiary of an IRA from his deceased father. Also assume that Jack receives SSI and is 35 years old. The special needs trust provides that at Jack’s death any remaining funds in the trust will go to his sister, Sarah, who is 52. The result is that Sarah’s age will be the measuring age for determining at what rate the payments from the retirement account must be distributed to the special needs trust. Since Sarah is older than Jack, the IRA must be distributed over a shorter period of time than if Jack’s age was used to determine the distribution rate.
Another important rule is that all beneficiaries of a trust that receives an inherited retirement account must be individuals in order for the trust to be entitled to receive funds from the retirement account on a stretched out basis. If any beneficiary is not an individual, then the retirement funds must be paid out within five years.
Importantly, a charity is not an individual for retirement plan purposes. If Jack’s special needs trust provided that at Jack’s death any remaining funds would be distributed to United Cerebral Palsy instead of to his sister, the distributions from the retirement fund to the special needs trust would have to be made over a five year period rather than over Jack’s life expectancy. Since parents often want the organization or organizations that cared for their child with a disability to receive the remaining funds in the special needs trust, this can be problematic.
When applying these basic rules about retirement benefits to planning in the special needs area, there are several conclusions that we can draw:
First and foremost, and worthy of repetition: Do not name your special needs child directly as a beneficiary of a retirement plan if your child receives or may later need SSI, Medicaid, or other benefits such as Section 8 assistance or food stamps. The distributions from the retirement account will either reduce the entitlements or eliminate them entirely. Instead, if you want your child to receive your retirement benefits, the named beneficiary on the account can be the special needs trust for your child.
Even so, this trust should contain special provisions not typically found in special needs trusts to insure the most favorable stretch-out and tax treatment discussed above. Consultation with a qualified expert is critical.
Second: Pay attention to the remainder beneficiaries in the special needs trust. In the example where Jack is 35 and his sister is 52, the funds will be distributed over the sister’s life expectancy using the applicable IRS tables. This means that the funds will have to be taken out over a shorter period of time, thereby reducing the time during which the assets could continue to grow tax free.
It also means that more income taxes may have to be paid by the special needs trust than if receipt of the retirement fund could be stretched out over a longer period. The result is even less favorable if a charity is named as the contingent beneficiary, which would require the funds to be distributed to the special needs trust within five years, resulting in large tax payments by the trust and reduced opportunities for growth.
Third: Given these complexities, parents should consider the possibility of leaving their retirement benefits to children without disabilities and leave other assets – cash, stocks, real estate, insurance, etc. – to the special needs trust. Leaving non-retirement assets to the special needs trust avoids the unsatisfactory consequences associated with the shorter pay-out required when the special needs trust names an older contingent beneficiary or where the parents would like to name a charity as a beneficiary of the trust. The retirement funds left to the children without disabilities can be stretched out to the extent permitted by law, and more of the favorable tax treatment and opportunities for tax deferred growth can be maintained.
While Roth IRAs do have mandatory annual distributions, they are not taxable to the beneficiary. Accordingly, the Roth IRA may be a good choice for funding a special needs trust , especially if the IRA names other individuals relatively near in age to the child with disabilities as the successor or contingent beneficiaries.
In any case, consulting a special needs lawyer who understands special needs entitlements, estate and income taxes and the rules regarding distributions from retirement plans is crucial when planning for the proper disposition of retirement assets for children with disabilities.