Taking Special Care with Inherited IRAs | Lord Abbett
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Practice Management

Clients with special-needs children must be careful in making plans for passing on their IRAs.

This Practice Management article is intended for financial advisors only (registered representatives of broker dealers or associated persons of Registered Investment Advisors).


As advances in medicine continue, it's become more likely that special-needs children may outlive their parents. For example, the average life expectancy of a person with Down syndrome is 60 today, compared with only 25 in 1983, according to the National Down Syndrome Society.

Yet many families remain unprepared. Two-thirds of parents with special-needs children have not prepared wills, according to a study by MetLife of more than 1,700 parents. Nearly one-third have done nothing at all to plan for their child's financial future.

Knowledgeable planning is essential to maximize the money available to special-needs beneficiaries after their parents' deaths. Poor planning can be costly. For example, in a recent private letter ruling (PLR 201116005), the IRS considered whether to allow a disabled beneficiary to transfer his share of two inherited IRAs to a special-needs trust, of which he was the named beneficiary.

Advisors can learn from this ruling and help families with special-needs beneficiaries preserve assets, and reduce unnecessary costs and losses. While not every client will have to deal with special-needs issues, nearly every advisor will.
The Facts
Consider the case of the disabled man, who was one of several beneficiaries of his father's IRA accounts. Because of his disability, the man was eligible-or potentially could be-for certain assistance programs, such as Medicaid. In order to preserve those benefits, the man did not want to be the direct beneficiary of the inherited retirement accounts. Instead, he proposed that his share of the inherited IRAs be transferred to a special-needs trust for his benefit. The inherited account would be set up as a properly titled inherited IRA benefiting the trust.

The man would be named as the trust's sole beneficiary during his lifetime. Like many special-needs trusts, this trust's provisions would allow the trustee to use his discretion to determine how much of the income and, if necessary, principal would be available for the man's benefit. The trust terms would, however, prevent any distributions that would reduce or eliminate any governmental assistance to which he was otherwise entitled.

At the man's death, any remaining trust assets would first be distributed to the state as repayment for his benefits, and any excess would then pass to his children; if he had no kids, then to his siblings. Most likely, the man would not want the remaining assets to go to the state, but since this proposed transfer was being done after the IRA owner's death (his father had not named the trust as the beneficiary), he had no choice.

To determine with certainty the tax effects of this transaction, the man' representatives asked the IRS to issue a private letter ruling that would continue to treat him as the owner of the trust's assets and therefore not trigger any income tax on the transfer of the inherited IRA to the special-needs trust, nor be considered a gift to the trust. The IRS ruled favorably in this case, as it did in two other similar private letter rulings (PLRs 200620025 and 200826008), citing a 1985 IRS revenue ruling. However, the father's failure to plan properly carried a severe cost.

No Strategy Substitute
For starters, this post-death transfer is still far from an established planning strategy. And requests for private rulings are expensive. This one cost $10,000-and that's just the IRS fee. Preparation could easily run as much, if not more. Alternatively, and relatively easily, the dad could have named the trust as the beneficiary of this son's share of the IRA.

There are two categories of special-needs trusts: first-party trusts and third-party trusts. Trusts funded by the beneficiary's own assets, such as the one described in this IRS ruling, are first-party trusts.

They can be used to help individuals with special needs reduce their total assets and income to qualify for Medicaid and other benefits but, upon the death of the grantor or beneficiary, any remaining trust assets must first be used to repay the state for any benefits that were provided. The trust in this case is a first-party trust because the IRA beneficiary was the son, not the special-needs trust.

Third-party special-needs trusts are funded with assets belonging to someone other than the individual with special needs, such as the beneficiary's parents. In such trusts, all remaining assets can pass to remainder beneficiaries once the special-needs person dies.

There is no requirement to repay the state for any benefits received. Had the father left this son's portion of his IRAs to a special-needs trust for his benefit (creating a third-party trust) instead of to him directly, he could have preserved far more of his IRA for future generations.

It is not clear whether the IRS's reasoning that a transfer of retirement funds to a grantor trust can be made without triggering a taxable event can be applied elsewhere. For instance, can an IRA owner make a transfer to a grantor trust during his or her lifetime? The answer, while inconsistent, appears to be no. The IRS has taken this position in the past, fortifying it in a recent private letter ruling (PLR 201117042).

When it comes to IRAs, trusts add significant complexity to the estate planning process. One main drawback is that any IRA distributions that are not distributed to the trust beneficiary each year are taxed at trust income tax rates.

While the maximum income tax rate is the same for trust and individuals, the trust brackets are highly compressed, meaning trusts reach the highest income tax rate at much lower income levels than individuals. These complications often lead IRA owners to abandon a trust in favor of a less complex approach. In some cases, however, such as when the intended beneficiary is a special needs person, a trust may be unavoidable.
Other Options
While a special-needs trust can be an attractive option in providing for a beneficiary with disabilities, there are other choices. For example, advisors could recommend using a portion of a client's IRA to purchase a life insurance policy, since it's a far better asset to leave to a special-needs trust than an IRA.

For starters, life insurance proceeds are free of income taxes, so the funds won't be depleted by taxes at accelerated trust tax rates as an IRA would be. In addition, life insurance proceeds eliminate the complications arising from the special trust language that's generally necessary to cover required minimum distributions from IRAs.

If an IRA owner can't qualify for life insurance or is unwilling to purchase it, a Roth conversion is another alternative. While the conversion may come with an upfront cost, the taxes will be paid at the IRA owner's personal rates, which may be much more favorable than trust tax rates. And even though there will be required minimum distributions from an inherited Roth IRA after the IRA owner dies, they will typically be free of income taxes to the special-needs trust.

IRA owners who will not or cannot purchase a life insurance policy and don't want to convert to a Roth IRA should still try to make effective planning choices. One possible decision is to fund the special-needs trust with non-IRA assets.

The client might consider leaving his IRA to his healthy children and his non-qualified account to his disabled child. Although the inherent inequality of this approach might dissuade some, complex IRA trust rules can be avoided altogether in the special-needs trust, making the post-death administration much easier for the trustee.
Tax Benefits
There are other advantages, as well. The special-needs trust would get the non-IRA assets, which upon the death of the owner would receive a step-up in basis, providing income tax-free assets.

In addition, the non-disabled beneficiaries receive the entire IRA, which they can stretch out over their lifetime, paying taxes at their personal rates. For most beneficiaries, this would be a rate lower than a trust would pay.

Be Proactive
Ask your clients whether any of their intended beneficiaries are disabled or have special needs, and whether they receive or may some day receive government assistance. You may understand the complications that can arise when such an individual is named as direct beneficiary of retirement assets, but clients may not. As a result, they may not volunteer this information.

It's crucial to remind your clients that if an individual with special needs inherits assets directly (as opposed to inheriting them though a trust), it may affect his or her eligibility for entitlement programs like Medicaid. To qualify, the beneficiary may first have to exhaust all or a large portion of his or her inheritance.

Often, it's clear early in a person's life that a mental or physical disability will create a need for governmental assistance. In other situations, an accident or illness later on may create the same requirement. Either way, savvy advance planning can go a long way in making sure that a beneficiary's special needs are addressed.

Ed Slott, a CPA in Rockville Centre, New York, is an IRA distribution expert, professional speaker, and author of several books on IRAs. For more information, visit irahelp.com.


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