Special needs trusts are a critical component of financial planning for families with loved ones with disabilities. But not all special needs trusts are created equal, and the type of trust you need depends on your family's unique situation.
In this blog, I take a look at the different types of special needs trusts, how they work, and when each might come into play.
Third-Party Special Needs Trusts
When I first started digging into my brother's finances, one of the first documents my parents showed me was his special needs trust.
This document was incredibly important to them, and I was told it was a foundational piece of Chris' financial plan. The trust was designed to help preserve his eligibility for critical Medicaid waiver services, including his job coach, living arrangement, and day support. Those services combined, over the next thirty years of his life, could be worth as much as $6,000,000-$7,000,000 (spending from $125,000-$150,000/year, 30 years, costs growing at 3% per year).
But that's about as far as our conversation went. I knew it was important, but we both weren't totally sure why.
Chris has what's called a third-party special needs trust.
A third-party special needs trust is funded with assets belonging to someone other than the beneficiary. These assets might come from parents, grandparents, siblings, or other relatives, but they typically aren’t Chris’ himself. That is a critical difference between third-party and first-party trusts, which I'll discuss more in a minute.
These trusts are often established as irrevocable trusts, although they can also be created through a revocable trust or become irrevocable upon the death of the person establishing the trust.
A few important features of properly drafted third-party special needs trusts include:
- Preserving benefits: Trust assets generally do not count toward Medicaid or Supplemental Security Income (SSI) resource limits when properly structured and administered.
- Remainder beneficiaries: Families can name individuals or charities to receive any remaining assets after the beneficiary passes away, without a Medicaid payback requirement.
Inherited retirement accounts: Qualifying special needs trusts may receive favorable required minimum distribution (RMD) treatment for inherited retirement accounts. - Estate planning flexibility: These trusts can help families provide for a loved one while coordinating inheritance and estate tax planning strategies.
A common misconception is that these trusts must be funded upon someone's death. In reality, third-party special needs trusts can also be funded during a beneficiary’s lifetime, which may make sense for families implementing estate or gift tax planning strategies.
First-Party Special Needs Trusts
A first-party special needs trust is another common type of trust, but it serves a different purpose.
These trusts are funded with the beneficiary's own money. For example, if an individual receives a personal injury settlement, is named directly as the beneficiary of a relative's inheritance, or accumulates assets that could jeopardize eligibility for means-tested benefits, a first-party special needs trust may be the right solution.
From a financial planning perspective, I often think of these trusts as a tool of last resort to help preserve critical Medicaid services when assets are already in the individual's name.
A few important features include:
- Preserving benefits: Assets held in a properly structured first-party special needs trust generally do not count toward Medicaid or SSI resource limits.
- Tax considerations: Depending on the trust's structure and tax treatment, income and capital gains may be taxed to the beneficiary or the trust.
- Medicaid payback: Unlike third-party trusts, first-party special needs trusts generally require remaining assets to reimburse Medicaid for qualifying benefits paid during the beneficiary's lifetime.
First-party trusts can play a major role in disability planning, but they aren't the only option I would consider. For an individual who is simply looking for somewhere to place excess cash, an ABLE account may offer a more straightforward and cost-effective solution, depending on eligibility, contribution limits, and the individual's circumstances.
Pooled Special Needs Trusts
The last type of special needs trust I wanted to cover is a pooled special needs trust.
A pooled special needs trust can be established with either first-party trust or third-party trust features. What makes pooled trusts different is that they are managed by a nonprofit organization, with assets “pooled” together for investment and administrative purposes while maintaining separate accounts for each beneficiary.
The pooling element can reduce some of the flexibility offered by individually managed trusts, but pooled trusts can be more economical to establish and provide professional trustees to help manage future spending needs.
A few important features include:
- Pooled investment management: Assets are combined for investment purposes, which can create efficiencies but may limit flexibility in investment selection and trustee decisions.
- First-party or third-party funding: Pooled trusts can accept either type of funding, subject to the specific trust's rules.
- Lower administrative burden: They can be more economical to establish and offer an existing trustee and administrative structure.
- Remainder provisions: Depending on the trust structure, remaining assets may pass to named beneficiaries, reimburse Medicaid, or be retained by the nonprofit pooled trust.
For families who don't have someone willing or able to serve as trustee, a pooled special needs trust can be an attractive alternative.
Trust Features
Once you've determined the type of trust that's right for your family's needs, there are a few additional features that impact financial planning strategies to build around them.
Accumulation vs. Conduit Trust
This distinction is important when inherited retirement accounts are passed to a third-party special needs trust. An accumulation trust, as the name suggests, can retain required minimum distributions (RMDs) from inherited retirement accounts. A conduit trust must pass those distributions directly to the beneficiary, which can cause issues for benefits eligibility.
Both structures may qualify for favorable inherited IRA distribution treatment, but the rules of each type differ significantly. It's very important to work with an attorney who knows these rules inside and out.
Testamentary vs. Living Trust
This distinction comes into play with third-party special needs trusts. A testamentary trust is created upon someone's death through provisions in their will. A living, or standalone, special needs trust is established during someone's lifetime.
A standalone trust can be a powerful financial planning tool when parents, grandparents, or other relatives want to gift assets or implement estate planning strategies with a loved one with special needs during their lifetime.
Choosing the Right Trust for Your Family
As I've learned through my own family's experience, simply having a special needs trust isn't the end of the planning process.
Understanding how the trust works, who can contribute to it, how distributions are managed, and what happens to the assets after the beneficiary passes away are all important considerations.
The right trust structure depends on the individual's needs, the benefits they receive, and the family's long-term goals. If your trust hasn't been reviewed in the past five years, consider getting a special needs attorney to review your document to make sure it’s up to date after recent law changes.
A special needs trust is an important tool, but making sure it's the right trust, and that it works alongside the rest of your financial plan, is just as important.
This article is for educational purposes only and is not individualized legal, tax, or financial advice. Special needs planning rules are complex and can vary based on individual circumstances. Families should consult qualified professionals familiar with special needs planning.
About Brett
Brett Corsello is a Partner and Portfolio Manager at Juno Financial Group in Richmond, VA, where he leads the firm’s Special Needs Financial Planning Practice. He is a Chartered Financial Analyst (CFA) and a Chartered Alternative Investment Analyst (CAIA).