“Carmen” had a daughter “Julie” who had disabilities and was on Medicaid among other government programs. When Carmen prepared her estate plan, she told her attorney about Julie’s disabilities and government benefits. As opposed to Medicare which most retirees are eligible for, Medicaid is a government health care program for those without money or income. In fact, an individual must have less than $2,000 of assets and may only have income of $2,094/month in order to so qualify. Any amounts above that would usually disqualify the recipient from receiving Medicaid benefits.

So Carmen did not want the amounts that she was leaving Julie to disqualify Julie from receiving her Medicaid benefits. Carmen’s estate-planning attorney did an excellent job drafting a Special Needs Trust naming Julie as a beneficiary after Carmen’s passing.

Special Needs Trusts (also known as Supplemental Needs Trusts) are designed to provide for those “extras” or necessaries that the government may not provide for, while at the same time not disqualifying the beneficiary from receiving much-needed government assistance. Those extras might include a single room in a care facility as opposed to a double room, a home, automobile, travel to visit relatives or even some prescription drugs.

While the attorney drafted an excellent trust, he did not consider something very important. Most of Carmen’s assets were in the form of IRA accounts. When Carmen withdraws money from her IRA account, the amount withdrawn is taxable income to Carmen. When Carmen dies naming Julie’s Special Needs Trust as the beneficiary, a number of serious tax problems arise.

First, the beneficiary of an IRA (who is not the spouse of the deceased) following the account owner’s death will have Required Minimum Distributions (RMDs) even if the beneficiary is not yet 70½ years old. Although in general the beneficiary may stretch out the RMDs over the beneficiary’s lifetime.

When a trust is named as the beneficiary, however, there are special IRS rules that must be met for the trust beneficiary to be considered the beneficiary of the IRA enabling the “stretch out.” These are known as the “identifiable beneficiary” rules. If all five of the identifiable beneficiary rules are not met, then the inherited IRA will generally distribute all of the assets in the year following the account owner’s death into the trust.

Special Needs Trusts, because they accumulate income, generally do not qualify the beneficiary as “identifiable.” So Carmen’s IRA would have distributed the entire account balance to the trust at Carmen’s death. This is a bad result since it results in the recognition of all of the income and hence the payment of the income tax, plus Julie lost all of the potential tax deferred growth over the course of her lifetime.

But this isn’t the end of the bad news. Since the Special Needs Trust is designed to hold all of the money that came into it, and only disburse it for those items that would not disqualify Julie from receiving Medicaid benefits, it accumulates all of the taxable income rather than distributing it. Testamentary (after death) irrevocable trusts (like the special needs trust) that accumulate income subject that income to a compressed income tax rate schedule. What this means is that to the extent that the distributions exceed $12,000 of taxable income, the highest marginal income tax bracket (39.6 percent) applies. Further, an additional Affordable Care Act (Obamacare) Medicare surtax of 3.8 percent would likely apply, resulting in a whopping 44.4 percent of the IRA benefits being lost to Uncle Sam in the year following Carmen’s death.

There are methods to plan around this potential disaster, and fortunately Carmen did amend her trust and therefore Julie will be well taken care of. This true story illustrates the importance of considering not only the legal aspects of estate planning, but the income tax planning aspects of the plan as well.

If a significant portion of your net worth is held in IRA or other qualified plan accounts, it behooves you to discuss the income tax consequences of your planning with a knowledgeable estate planning attorney.

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