Written by: Rebecca H. Williams, CFP®
April 8th, 2014
To continue the previous discussion about whether or not you should leave an IRA to your child’s 3rdParty Special Needs Trust (when referencing a Special Needs Trust in this article, I will be referring to a 3rd Party Special Needs Trust), we discussed the fact that in order to keep your loved one from being disqualified from means-tested government benefits; a Special Needs Trust must be set up as an accumulation trust rather than a conduit trust (remember, when drafted properly, an accumulation trust will allow the IRA distributions to ‘accumulate’ in the trust rather than being paid out directly to the beneficiary so as not to lose valuable means-tested government benefits).
In order to receive the favorable tax treatment of the IRA stretch out provisions, the Special Needs Trust must be considered an accumulation trust and a look-through trust which means that at the time of the IRA holder’s death, the beneficiary must qualify as a ‘designated beneficiary’ (an individual able to receive distributions outright). Obviously, in the case of a beneficiary who is receiving means-tested government benefits, receiving these distributions outright would mean disqualification from said benefits.
However, designating a natural person as the Remaindermen (he who would receive any remaining assets in the trust after the death of the beneficiary with special needs), would qualify the Special Needs Trust as a look-through trust and therefore, the IRA would be able to be stretched out over the life of the eldest beneficiary.
If the IRA owner died before receiving RMDs (Required Minimum Distributions), then the IRA could be stretched out over the life expectancy of the eldest beneficiary which is a great tax advantage when you have younger beneficiaries. If the IRA owner passes away after RMDs have started, then the IRA must be paid out over the single life expectancy of the IRA holder at the time of death (but not longer than 15.3 years).
The problem that arises is what to do when the Remaindermen is not a natural person. It is very common in Special Needs Planning for a family to desire to leave assets to a charity or organization that provided care or services to their loved one during their lifetime. However, by naming a non-natural person, such as a charity, as a Remaindermen, we have just disqualified the trust as a look-through trust and, as such, have lost the favorable tax treatment that can come from stretching an IRA out over the beneficiary’s life expectancy (in lieu of paying it out within 5 years of the IRA holder’s death).
A solution to this problem could involve the use of another type of trust called a Charitable Remainder Trust (CRT). A CRT is an irrevocable trust that receives a gift from you, the Donor, and pays a designated person, the Income Beneficiary, income generated from the asset over the life of the Income Beneficiary or over a specified period of time (no longer than 20 years). Once the beneficiary passes away, or the term specified in the trust ends, the income stream would cease and the remaining assets in the trust will go to the charity.
So how does this strategy work? The CRT would be created and would receive full distribution of the IRA upon the account holder’s death. Since the CRT is exempt from income taxation (as long as the charity is a qualified charity under IRS rules), there is no concern to stretch out the IRA because the charity does not pay income tax on the IRA.
The CRT would then pay an irrevocable income stream to the 3rd Party Special Needs Trust (the income beneficiary) which would be taxed as ordinary income. The Special Needs Trust would also name a Remaindermen which could be either a natural person a charity.
There is another strategy which could be employed to direct funds from an IRA to a Special Needs Trust in a tax efficient manner. This strategy would use both a 1st Party and a 3rd Party Special Needs Trust and I will talk about that in next week’s blog…stay tuned!
*There are very specific guidelines that must be followed when drafting a Charitable Remainder Trust and/or A Special Needs Trust thus it is strongly recommended to seek the professional guidance of professionals experienced in these planning areas.
*Nothing in this article should be taken as legal or tax advice. For advice in those areas please consult your own legal or tax professional.