Retirement Accounts and Special Needs Trusts
By Evan J. Krame
At the end of 2019, the law governing retirement account distributions changed significantly. Until the passage of the SECURE Act, beneficiaries might qualify to stretch out an inherited IRA account over their lifetimes. Now, most designated beneficiaries have no more than ten (10) years to receive their IRA distributions. While the stretch has snapped back, disabled beneficiaries can still benefit from the extended lifetime payout.
The SECURE Act makes exceptions for IRA beneficiaries who are considered disabled. The disabled person has to meet the definition which requires the individual to be unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment for an indefinite duration. Internal Revenue Code Section 72(m)(7). How does one know that they are qualified as disabled? As the regulations are not yet written, there is no uniform standard to follow and some doubt remains.
Disabled individuals will fit the category of “eligible designated beneficiaries” who can receive the funds in the form of required minimum distributions based on their life expectancy rather than within 10 years. Also excluded from the 10-year rule are beneficiaries who are considered chronically ill or who are less than 10 years younger than the account owner.
Initial drafts of the law did not allow for trusts to qualify for lifetime distributions. Last minute efforts brought about a further exception for qualified disability trusts. For example, the IRA owner can designate a Special Needs Trust as the beneficiary instead of the individual. These are third-party trusts (created most often by a parent for a child) that allow the beneficiary to remain qualified for Medicaid and SSI.
The trustee can use the required minimum distributions (“RMD”) to pay for the care and support of the person with special needs. There are two formats for such trusts. The first and less preferable way to set this up is through what’s known as a “conduit” trust.
Conduit trusts are compelled to distribute the RMD income received on a current basis. More typically used for inherited IRAs are special needs trusts drafted as “accumulation” trusts. Unlike conduit trusts, they do not require that the RMDs be distributed out because doing so could undermine eligibility for public benefits the disabled beneficiary may be receiving. Instead, they can be retained by the trust and distributed as the trustees deem appropriate.(What You Can Expect From A Trustee?).
The exception to the 10-year rule applies if the disabled beneficiary is the sole lifetime beneficiary of the trust. However, if the trust is a multi-beneficiary trust, there are still planning opportunities. See Internal Revenue Code §401(a) (9) (H) (iv) (I). These are called “applicable multi-beneficiary trusts.” To qualify as an “applicable multi-beneficiary trust,” the trust would have to be established in one of two ways.
The first possibility is that it can provide that it is to be divided immediately upon the death of the IRA owner into separate trusts for each beneficiary. The other possibility is that the “applicable multi-beneficiary trust” can provide that no beneficiary, other the disabled or chronically ill beneficiary, has any right to the IRA funds until the death of the eligible designated beneficiary. But the trust will only qualify for this treatment if the disabled individual is the only beneficiary of the trust share or IRA distributions during his or her life. If the trust also permits distributions to a spouse, siblings or children, it won’t qualify, and the IRA will have to be completely withdrawn under the 10-year rule.
Moreover, the trust cannot include a provision that changes the character of the special needs trust if the beneficiary no longer qualifies for government benefits. There can be no possibility that the income and/or principal will go to alternate beneficiaries while the eligible designated beneficiary is alive.
Only when the disabled beneficiary dies will the alternate beneficiaries receive anything from the trust and then the distributions will pass under the 10-year rule unless the alternate beneficiaries are also eligible designated beneficiaries.
Drafting a qualified trust for an eligible beneficiary is tricky. For the attorney, there is some guidance if we can follow the rubric of Qualified Disability Trusts found in Section 642 of the Internal Revenue Code. Existing special needs trusts designated as an IRA beneficiary should be reviewed promptly.