Retirement Weekly: How can we provide for our disabled daughter in our estate plan?

Q.: Hi Dan,

 Can a trust and/or a special needs trust be the beneficiary of an IRA? Our special needs daughter cannot be a named beneficiary, but we have substantial assets in our IRA accounts. Same question for our large life insurance policies. 

Thanks so much! Peggy

Read: Financial planning for children with disabilities is stressful — here are some resources for parents

A.: Hi Peggy,

Special needs is an area of the law that varies from state to state and can get complex fast. This is no place for a DIY approach. You should engage a qualified attorney with expertise in special needs planning to determine what is best for you and your family. I am not a lawyer so I am only going to answer with some generalities here.

Yes, you can name a trust as beneficiary. The oversimplified explanation of the tax treatment is that income that is paid from the trust to the beneficiary is typically reported on the beneficiary’s tax return and taxes are paid at the beneficiary’s rate. Whereas the income that stays in the trust is reported on the trust’s tax return and paid at rates applicable to trusts.

The differences between individual and trust tax scales are dramatic. In 2022, for a single taxpayer to reach the highest marginal federal tax bracket of 37%, they need to have taxable income over $539,900. A trust needs a mere $13,450 of taxable income to reach the 37% rate.

Because of this difference, most people want the income from an IRA to flow through the trust to the beneficiaries. There are requirements that if met can make that possible. Generally, the trust must be valid in the state where it was established and be irrevocable or become irrevocable following the death of the grantor. The beneficiaries must be identifiable, and the trustee must provide the custodian of the account with requisite documentation by Oct. 31 of the year that follows the year of the grantor’s death.

However, having the IRA distributions flow through to the beneficiary can cause problems when the purpose of the trust is to restrict cash flow. Restricting cash flow is one reason people use trusts. Trusts are set up for many nontax reasons such as to protect assets from creditors, protect assets from a beneficiary’s bad financial habits, or to provide for a special needs beneficiary via a special needs trust.

An issue with a special needs trust is it is only supposed to pay out funds to the beneficiary for specified expenses. If it distributes funds for other expenses or the beneficiary’s income is too high, those distributions can disqualify the beneficiary from benefits they would otherwise be entitled to.

When such a trust is funded with IRA money, the funds flowing from the IRA to the special needs trust are generally taxable income and can easily exceed what should be paid out to maintain benefits. Therefore, the distributions from the IRA are often retained within the trust where it is taxed at those high trust rates. 

This does not mean that you should never fund a trust with IRA money. It just means the tax treatment can be more favorable using other means if available.

For instance, life insurance proceeds are attractive for funding special needs trusts. If set up correctly, the proceeds would be received by the trust tax-free as the beneficiary of the life insurance. There would still be taxable items to manage such as interest, dividends and capital gains earned on the life insurance proceeds once invested within the trust, but those will result in a lower tax bill than funding the trust with purely pretax IRA money.

If you have a question for Dan, please email him with ‘MarketWatch Q&A’ on the subject line. 

Dan Moisand is a financial planner at Moisand Fitzgerald Tamayo serving clients nationwide from offices in Orlando, Melbourne, and Tampa Florida. His comments are for informational purposes only and are not a substitute for personalized advice. Consult your adviser about what is best for you. Some reader questions are edited to aid the presentation of the subject matter.

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