Tax Treatments Aren’t Always Favorable
SNTs operate as pass-through entities, and the tax treatment favors ongoing distributions to the beneficiary. Any earned investment income usually goes to the beneficiary that same year, with the distributions taxed at the beneficiary’s income tax rate. Trust assets can help cover the tax bill.
As long as all the annual income is distributed in a given year, the trust won’t owe any tax, but a return will need to be filed to report the income. For any undistributed annual investment income, the trust is taxed at one of four levels of tax rates, which are each much higher than those for individuals. For instance, the lowest income tax rate for a single person in 2022 is 10% for the first $10,275 in income. The trust, however, gets the benefit of that 10% rate only for the first $2,750 of income before the rate jumps to the next tier at 24%, and the highest trust tax rate — 37% — kicks in at just $13,451 of income. An individual isn’t taxed at 37% until earnings top $539,900.
Most trusts that are set up in advance for a family member are third party trusts — those funded by another person on behalf of the disabled individual. A first party special needs trust is typically created when a disabled person receives money directly, such as a cash settlement after an accident that caused the disability.
The Retirement Savings Decision
The assets are transferred to the trust when it’s funded, either at your death or during your lifetime. An SNT can be set up as a revocable trust, allowing you to reclaim the assets if they’re needed. Cash, investment accounts, real estate or proceeds from a life insurance policy are common ways to fund the trust, but be careful about transferring a retirement savings account to an SNT. If you do so while you’re alive, the amount transferred to the trust is considered a withdrawal. For pre-tax accounts like a 401(k) or traditional IRA, you would owe income tax on the entire account balance when it’s used to fund the trust.
You could name an SNT as the beneficiary of your traditional retirement account when you die instead. The investments will continue growing tax-deferred as long as they remain in the retirement account. The trust will collect the required minimum distributions from the retirement account each year and pass the money on to the beneficiary as income. But, as with all of the trust’s annual income, any undistributed amount of the required distribution, perhaps because it’s more than the beneficiary can spend, is taxed at the trust’s higher tax rate.
The Setting Every Community Up for Retirement Enhancement Act does give preferential treatment to a disabled family member who inherits a retirement savings account directly, meaning the trust is not named as the beneficiary. Under the 2019 law, when most people inherit a retirement account, they must withdraw the entire balance within 10 years and pay the taxes. But heirs with a disability are permitted to spread those withdrawals over their entire lifetime, whether they are named as the account’s direct beneficiary or an SNT is.
Of course, leaving the retirement account directly to a special needs heir would likely disqualify the person from getting Medicaid and Social Security assistance. You’ll need to work with a financial adviser and estate planner who understand the eligibility rules for government benefits and retirement taxes to determine which approach is best. Usually, you have to choose between maximizing tax planning or benefits planning.
This commentary was originally posted by David Rodeck June 8, 2022
Source: Estate Planning: A Special Trust for a Special Need | Kiplinger
**Disclaimer: This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.