Special Needs Trust: Benefits, Rules and Considerations

Families that have a loved one with special needs may want to consider setting up a special needs trust. It's a powerful tool that can help provide for someone with a disability or chronic illness without compromising their ability to qualify for needs-based government benefits.

For someone unable to earn or manage money on their own, a trust can serve as an invaluable lifeline. It may also give relatives the peace of mind that comes from knowing that a loved one will be taken care of in the future.

That's why many parents, grandparents and other relatives choose to create and fund a special needs trust. This kind of trust is specifically designed to provide ongoing financial support for people with a physical or mental disability or a chronic illness—while maintaining their ability to access government benefits, such as Supplemental Security Income, or SSI, and Medicaid.

Benefits of a special needs trust

Once a special needs trust is funded, the trust itself, rather than the beneficiary, owns the assets. This is particularly beneficial for people with a disability because the assets won't count against them for income or asset-capped government benefits.

"We have clients who could afford to self-fund ongoing expenses for a young or adult child with special needs," says Nerre Shuriah, JD, LLM, SVP and Senior Wealth Planning Director at First Citizens. "But there are things—like occupational therapies—that government programs like Medicaid provide that would be prohibitively expensive if you're paying for them personally."

Helping beneficiaries qualify for assistance isn't the only advantage of these trusts. Other benefits include:

• Supervised funding for quality-of-life expenses
• Protection from creditors and lawsuits
• Ongoing asset management
• Fiduciary protection against financial abuse

The trust can go into effect immediately and remain in place after the grantor has passed away, or it can be a testamentary trust, which means it's both funded and goes into effect after the grantor has passed away.

Special needs trust spending rules

Generally, government assistance covers essential living expenses like shelter, food and healthcare. For a beneficiary to maintain eligibility for these programs, the trust can only pay for expenses beyond these basics. This may include expenses such as education, clothes, toiletries, renovations necessary to adapt a home to the beneficiary's need and any medical therapies that Medicaid doesn't cover.

What's more, the trust can't make direct cash disbursements. "If the beneficiary needs a new phone or car, or even books for school, the trustee has to pay for these things directly," Shuriah says. It's important to know that states—as well as the trust itself—may impose additional restrictions on how the beneficiary can use the funds.

Shuriah suggests that the grantor consider writing a letter of intent when creating the trust. While not legally enforceable, such a document can provide guidance that the trustee can follow to carry out the grantor's wishes.

The role of a trustee

An important part of setting up a special needs trust is choosing a trustee. The individual or institution that assumes this role will have a fiduciary responsibility to manage the trust and distribute funds to the beneficiary.

"A trustee has a legal duty to the beneficiary, and they have to be very careful to follow the terms of the trust document because they're personally liable for mistakes," Shuriah says.

Named at the establishment of the trust, the trustee can be a reliable family member or a financial institution that offers personal trust services. "In general, those setting up a trust should look for a trustee that is financially literate, willing to serve and geographically close to the beneficiary," Shuriah says.

Also, the rule requiring direct payments means the trustee must make disbursement-related decisions. "That's a much more intensive, personal role than with other trusts, so it requires a lot of empathy," she adds.

While many families consider naming a sibling of the person with a disability as the trustee, Shuriah says to proceed with caution. Siblings may not want the responsibility, or their circumstances may change over time. For those reasons and to provide continuity in decision-making, it may make sense to opt for a corporate trustee.

Types of special needs trusts

There are two primary types of special needs trusts: third-party and first-party. There's an additional type called a pooled special needs trust, which can be either a third-party or first-party trust. Here are some key differences.

Third-party special needs trust

This is the most common form of special needs trust, in which a parent, grandparent or other loved one sets up the trust on behalf of the individual with a disability. With this type of trust, you may name a secondary beneficiary who would receive the assets in the trust when the primary beneficiary passes away.

First-party special needs trust

Also known as a self-funded or self-settled trust, beneficiaries themselves create this type of trust. Rules for special needs trusts established in 2016 allow self-funding as long as the individual is deemed mentally capable yet also meets the US government's definition of disabled.

Often, the beneficiary has received a settlement or court judgment and decides to put the funds into a special needs trust to avoid compromising their SSI or Medicaid benefits. Notably, a first-party special needs trust is subject to payback rules for Medicaid, which means that after the beneficiary passes away, any remaining assets must go toward paying back Medicaid for expenses incurred during the beneficiary's life.

Pooled special needs trust

With a pooled special needs trust, the grantor works with a nonprofit that manages one large trust with sub-accounts for the benefit of individuals. This type of trust may have lower costs than the other types—primarily because you're splitting administration costs and may be accessing scaled pricing for investments.

How to establish and fund a special needs trust

Like any other trust, setting up a special needs trust is a legal process that requires an experienced attorney to create the trust documents. Experience is key here because making mistakes in wording can create issues that disqualify beneficiaries from receiving benefits. Ensure you work with an institution that has experience establishing special needs trusts and that takes your wishes into careful consideration.

Once you've established the trust with a financial institution, you can fund it with various assets, including property, cash and investments. You can also name a trust as the beneficiary of a life insurance policy so the proceeds from that policy will go into the trust when you pass away.

Shuriah suggests grantors who are considering putting any real estate into the trust ensure the property isn't encumbered with a mortgage or lien and that there are enough funds in the trust to cover the cost of maintaining the property, as well as paying taxes and other costs associated with it.

If a grantor is considering making the special needs trust a beneficiary of a qualified retirement plan or individual retirement account, or IRA, they'll want to ensure they have the guidance of a competent attorney to navigate the complexities. "A special needs trust may be able to fall within the exception for a disabled-eligible designated beneficiary and receive a payout over the beneficiary's lifetime because there is typically only one beneficiary for the trust," Shuriah explains. "An attorney is required to draft the trust correctly to ensure the beneficiary fulfills the definition of eligible designated beneficiary under the SECURE Act statute." She adds that additional regulations are anticipated around this exception to provide more clarification.

When family members set up a special needs trust, it's imperative that they tell others who may want to make a gift to the beneficiary. "Make sure that relatives like the grandparents know that they should direct future gifts and inheritances to the trust and not the individual," Shuriah says. "Individual gifts can really undermine the whole process of qualifying for benefits."

Key considerations

Setting up a special needs trust to manage assets and spending for an adult child with a disability can reassure parents and grandparents that the child will have the financial support they need to thrive for the entirety of their lives. However, there are several factors to consider.

First and foremost, Shuriah recommends considering the independence level of the beneficiary before choosing to go the route of a special needs trust and working with a financial professional to see if other tools might also help the family reach its goals.

"The special needs trust really takes away all of their independence, since they have to go to the trustee for all requests," she explains. "So, if they're still able to function independently, you might consider some other means, such as an Achieving a Better Life Experience, or ABLE, account."

Special needs trusts are also subject to strict regulation—making them less flexible than other types of trusts, with significant restrictions on how much control the beneficiary has over funds in the account. These trusts are also irrevocable, which means you can't change your mind and close a trust once you've put assets into it.

The bottom line

A special needs trust can help provide ongoing financial support for a loved one with a disability without compromising their eligibility for key government benefits. The rules and regulations can get complicated, however, so it's a good idea to seek professional advice before making this decision.

Financial professionals with in-depth expertise creating and managing trusts like these can walk you through the considerations and help you determine whether a special needs trust is right for your loved one.