Special Needs Planning and Retirement Benefits

Retirement accounts like 401(k)s and IRAs make up the majority of most people's savings. While these plans encourage saving by offering significant tax rewards, they were certainly not set up to help families with special needs, who are typically trying to provide a protected source of liquid funds for a child long into the future.

The biggest problem with retirement benefits when it comes to special needs planning is that most retirement plans require some form of distribution from the account once an account owner dies, especially if the account names someone other than the account owner's spouse as a beneficiary.

In these cases, naming a child with special needs as a direct beneficiary of a retirement account can affect the child's ability to access government benefits. This is so because the income received from the retirement account is counted when it comes time to determine the child's eligibility for Supplemental Security Income (SSI), Medicaid, housing benefits and a host of other programs. In general, if a child is receiving or expects to receive benefits from any of these programs, or if he is simply not good with money, then he shouldn't be named as the direct beneficiary of a retirement account.

In order to avoid this problem, many people seek to name a special needs trust that benefits the child as the beneficiary of a retirement plan. When properly constructed, the special needs trust can hold the distributions from the retirement plan for the child's benefit without endangering his eligibility for government services. However, this strategy has three main drawbacks.

First, if the trust for a child with special needs names a charity as the ultimate beneficiary when the child passes away, then the entire retirement account must pay out into the trust within five years from the account owner's death. This could create an income tax penalty because distributions from the retirement plan are taxed as income in the year they are taken. These distributions, if retained in the trust, will be taxed at the trust tax rate, which is usually much higher than the individual tax rate.

Second, if the trust names other people as the so-called remainder beneficiaries (those who receive what remains in the trust after the original beneficiary’s death), and any of those beneficiaries is older than the child, then the retirement account must make payments into the trust based on the age of the oldest beneficiary. This, too could increase the income tax penalty.

Finally, because in most cases the trust income tax rate is significantly higher than the individual tax rate, income held by the trust and not used for the benefit of the child with special needs will be further reduced by excessive income taxes.

In many cases, the benefits of using a special needs trust to hold retirement benefits outweigh the alternatives. However, some families who have other assets available, like cash, investment accounts or life insurance, may want to use those to fund the special needs trust while leaving the retirement benefits to other children. Also some retirement plans, such as Roth IRAs, do not generate taxable income when they are cashed out, making them a better choice to fund a special needs trust. In any case, consultation with a special needs planner is a must before naming or changing beneficiaries of any retirement account.