If you have an individual with special needs in your life, it is paramount to understand how special needs trusts operate and how the government taxes them.
Special needs trusts are for estate planners wishing to make provisions for persons on Supplemental Security Income, or SSI. One of the major issues concerning SSI is the strict limits on how much an SSI recipient may have in assets. This means that if an SSI recipient suddenly gets a large inheritance, said recipient may lose their Medicaid or Medi-Cal benefits. Losing access to these benefits is often a literal matter of life and death for a person with special needs. This is why special needs trusts exist: they are a way of providing for individuals with special needs without threatening their government-provided medical benefits.
While special needs trusts are a powerful estate planning tool that protects some of the most vulnerable people, taxes still apply to them. In the majority of cases, special needs trusts are third party, and the government taxes them as a pass-through entity.
The Tax Situation of Special Needs Trusts
In the case of a third party trust, the special needs trust will need to file a tax return each year. This document shows how much the trust “earned” over this period of time. You must report any realized gains, dividends, or interest.
Once you calculate this number, you may then deduct any distributions that the trust made to the beneficiary. The trust will not pay any tax on income it generates that goes to the beneficiary. It is only the gains that remain in the trust that the government will tax at a trust tax rate.
The government taxes any income that the trust passes to the beneficiary at the beneficiary’s individual tax rate. In the majority of cases, the trust tax rate is higher than the beneficiary’s individual tax rate. Because of this, it is generally wise to pass on as much income each year to the beneficiary as possible, if this is appropriate to the situation at hand.
Essentially, special needs trusts are not tax-free. It just makes it possible to distribute income at a (generally) lower beneficiary’s rate.
In the event of a first party self-funded special needs trust, there are no trust-level taxes. The government taxes all income from these special needs trusts directly to the beneficiary.
Who Pays the Taxes?
The trustee typically holds responsibility for filing the tax returns and handling the trust’s portion of the taxes. In most cases, the trustee should also assist the beneficiary in ensuring that the beneficiary files their taxes correctly. It is also possible for the trustee to use trust funds to pay for the beneficiary’s portion of the tax.
It is generally wise for the trustee to review the trust on a quarterly basis, to ensure that costs to the trust do not become overly large. Remember that activity on the account raises costs, and these can become problematic at tax time.
Contact us at AmeriEstate to learn more about how we can help you protect your loved ones with special needs trusts.
Sources:
https://www.ssa.gov/benefits/disability/
https://www.forbes.com/advisor/life-insurance/special-needs-trusts/