Passing Retirement Benefits to a Child With Special Needs

Takeaways

• Under the SECURE Act, disabled beneficiaries can stretch out inherited retirement account distributions beyond 10 years, provided their life expectancy is longer than the default 10-year rule.

• Generally, an Applicable Multi-Beneficiary Trust (AMBT) is the best choice for passing retirement accounts on to beneficiaries with disabilities. An AMBT, as a see-through accumulation trust, protects the disabled beneficiary’s public benefits eligibility.

Many parents have their retirement savings socked away in 401(k) plans and individual retirement accounts (IRAs). Retirement assets make up approximately one-third of all household financial assets in the United States. At the end of the second quarter in 2024, 401(k)s held around $8 trillion in assets and IRAs held $14.5 trillion.

Retirement accounts figure heavily in most estate plans. To ensure that one’s beneficiaries do not have to pay taxes on the funds prematurely, it’s important to structure the beneficiary designations properly for these accounts. This is complicated enough, but when a beneficiary has special needs, things can get even trickier, especially with recent legislation that affects retirement account planning.

For one, passing money from an inherited retirement account to an adult child who has a disability could end up jeopardizing their eligibility for public benefits such as Supplemental Security Income (SSI) or Medicaid. However, if you make a trust the beneficiary of your retirement account, there could be adverse income tax consequences.

With proper special needs trust drafting, you can usually prevent undesired results. Here’s a rundown of the major laws and issues.

Understanding Required Minimum Distributions

Federal law generally requires that you withdraw a minimum amount from your tax-deferred retirement accounts, including 401(k) plans and IRAs. These required minimum distributions (RMDs) start when the account holder reaches a specified age and continue over a period during which they must withdraw the entire account balance. RMDs then continue after death when the account is passed to beneficiaries.

Generally, most beneficiaries of an inherited retirement account must withdraw all the money — and pay all the applicable income taxes — from the account within 10 years of the account holder’s death. The RMDs are based on their life expectancy.

The Setting Every Community Up for Retirement Enhancement (SECURE) Act, passed in 2019, created an exception to the 10-year rule for individuals considered Eligible Designated Beneficiaries (EDBs), a category that includes beneficiaries who have a disability or chronic illness.

Because disabled beneficiaries are EDBs, they have the option to “stretch” account distributions out beyond 10 years. Provided that the disabled beneficiary’s life expectancy is longer than the default 10-year rule, a lifetime payout strategy allows the individual to receive smaller distributions over a longer period and continued tax-deferred growth.

The SECURE Act and Special Needs Trusts

While the SECURE Act places some limitations on inherited retirement accounts, the legislation did not change the goal or the basic planning strategy for a disabled child inheriting a parent’s retirement assets.

A retirement account holder can name a special needs trust (SNT) as the account beneficiary. A trustee can then use funds from that account to pay for care and support services for the person with special needs that are not covered by government benefits, such as education, recreation, and medical equipment.

In that case, the RMDs would then be based on the life expectancy of the oldest beneficiary named in the trust.

For a trust (rather than an individual) to qualify as a designated beneficiary, it must be a see-through trust. The requirements for this are as follows:

• The trust is valid under state law;
• It must be irrevocable, or by its terms will become irrevocable at the death of the account owner;
• All trust beneficiaries must be clearly identifiable;
• Proper documentation has been provided to the plan administrator.

These facts must all exist as of October 31 of the year after the year the retirement account holder has died.

Conduit vs. Accumulation Trusts

Planning for a disabled child to receive a retirement account through an SNT is relatively straightforward when the disabled child is the sole account beneficiary. Matters get more complicated when there are multiple beneficiaries.

Often, the most difficult step is identifying every potential beneficiary and determining who is the oldest.

At first glance, it would seem that the easiest way to satisfy this requirement is to use a so-called “conduit” trust. This type of trust requires that the trust assets be distributed immediately to the primary beneficiary. Distributions are based on the life expectancy of the primary beneficiary, and the IRS does not look at the ages of any other beneficiaries. However, this doesn’t work for SNTs because the distributions would likely invalidate a disabled beneficiary’s public benefits eligibility.

The alternative is a so-called “accumulation” trust, which permits funds to be held by the trust, rather than requiring their distribution. RMDs can still be stretched out based on the life expectancy of the oldest beneficiary, but the IRS will look at all the potential beneficiaries of the trust.

However, things can easily go awry with this strategy. For example, a provision in the trust saying that funds will be held for the benefit of a minor can be problematic, depending on what the trust says will happen to the trust funds if the minor dies before distribution.

In short, you can create an SNT as an accumulation trust that will be treated as a designated beneficiary by the IRS, but you need to be careful to avoid potential tax consequences.

Under the SECURE Act, the 10-year rule exemption for disabled and chronically ill people applies only if the disabled or chronically ill individual is the sole beneficiary of the trust during their lifetime. If the trust also permits distributions to any other individuals, it won’t qualify. The retirement account will then need to be completely withdrawn within 10 years, and taxes on those distributions paid within the same period.

Applicable Multi-Beneficiary Trusts (AMBTs)

Generally, the best choice for passing retirement accounts on to beneficiaries with disabilities comes in the form of an Applicable Multi-Beneficiary Trust (AMBT).

An AMBT is a see-through accumulation trust for which an individual with a disability or chronic illness can be a designated beneficiary of a retirement account. RMDs paid to the AMBT do not have to be distributed immediately to the disabled or chronically ill beneficiary, which can protect them from the potential loss of public benefits.

At the same time, an AMBT that is drafted correctly qualifies for the lifetime stretch. SECURE and its accompanying regulations outlined specific requirements that AMBTs must meet for a beneficiary who has a disability or chronic illness, so it is essential to work with your special needs planning attorney when creating this type of trust.

SNTs and Remainder Beneficiaries

Under the initial SECURE Act, SNTs that included charities as remainder beneficiaries — those beneficiaries who receive trust assets after the primary beneficiary has passed away — could not use the lifetime stretch.

In 2022, Congress passed SECURE 2.0, expanding on and amending certain provisions in the SECURE Act, including rules regarding AMBTs. Among the changes wrought by SECURE 2.0 was a provision allowing SNTs to have charitable remainder beneficiaries if the trust qualified as a certain type of AMBT.

For the EDB’s life expectancy to be the determining distribution factor, the trust’s primary beneficiary (i.e., the disabled person) must be the only beneficiary during their lifetime. Careful drafting of the trust documents helps to ensure that remainder beneficiaries are not considered until after the disabled EDB’s death.

Other Strategies to Consider

An alternative strategy, if you have more than one child, is to allocate your retirement assets to the SNT, where the beneficiary with the disability can get lifetime stretch, and name the other children in the family as the beneficiaries of your nonretirement accounts. Although this approach may be simpler, it’s sometimes difficult to equalize the amounts among multiple children.

The preferred solution may be to set up a see-through accumulation trust for your special needs child and establish a separate trust for your other heirs.

You could also just decide that it’s OK for the trust to pay taxes on its share of your retirement plan within 10 years of your death. The taxes will need to be paid eventually in any case, and if your retirement account is divided into several shares, the amount of the distributions per person may be relatively small.

Each choice has its pluses and minuses. To work through the pros and cons of the different options available for inherited retirement accounts, and which option is best for you and your disabled child, talk to a local special needs planner.

Learn more about estate planning for families with disabilities in the following articles:

• Building an Estate Plan for an Adult Child With Disabilities
• How Life Insurance Can Be Used to Fund a Special Needs Trust
• How Third-Party Special Needs Trusts Differ From Other SNTs