by David M. Cordell, Ph.D., CFP®, CFA, CLU®; and Thomas P. Landgon, J.D., LL.M., CFP®, CFA
David M. Cordell, Ph.D., CFP®, CFA, CLU®, is director of finance programs at the University of Texas at Dallas.
Thomas P. Langdon, J.D., LL.M., CFP®, CFA, is professor of business law at Roger Williams University in Bristol, Rhode Island.
Parents of children with autism, Down syndrome, and other income-limiting physical or psychiatric conditions bear a special burden that is both financial and emotional. A valuable financial planning tool that can address the financial burden, and thereby help with the emotional burden, is the special needs trust (SNT).
SNTs are designed to protect assets that can be used for the benefit of an individual with special needs who is receiving state assistance due to his or her condition. Given the recent changes in income tax laws effective January 1, 2013, life insurance has become a more attractive funding mechanism for SNTs.
Providing for the Special Needs Child
Assets are transferred to those with special needs in many ways. Most of the standard transfer techniques, however, pose unique planning challenges when special needs individuals are involved. A parent could make an inter-vivos or testamentary transfer of assets directly to a special needs child, but receipt of a direct transfer may disqualify the child from receiving needs-based government benefits.
An alternative to transferring assets to the special needs individual is to disinherit him or her so that the individual qualifies for government benefits. Typically, though, this approach is inconsistent with the objectives of the parents or other family members who want to provide an opportunity for the child to live the best life possible.
Another approach is to leave assets to a third party (such as a sibling, cousin, or close family friend) who promises to use those assets for the benefit of the child. The obvious shortcoming to this approach is that, while well intentioned, it is not legally enforceable and may result in depriving the child the use of those assets. Parents who want to ensure that funds will be available to support a special needs child are left with one viable option, the special needs trust.
Special Needs Trusts
Typically, a special needs trust is established as a third-party supplemental needs trust. SNTs are created and funded by someone other than the beneficiary (typically the parent), and expressly state that the trustee may only distribute trust income and assets for the beneficiary’s needs in excess of services provided by the government. The trustee’s ability to distribute income or principal is discretionary, making it impossible for the beneficiary, or any other party on behalf of the beneficiary, to require the trustee to make a distribution.
The trust also includes a spendthrift clause, which places the assets beyond the reach of the beneficiary’s creditors. Any assets remaining in the trust at the beneficiary’s death typically are transferred to other family members of the grantor or to a charitable organization.
The trustee’s discretionary authority to distribute income implies that the trustee has the authority not to distribute trust income if he or she does not feel a distribution would be prudent. SNTs, like all other non-charitable trusts, are subject to income tax on trust income that is retained by the trust and is not distributed to the beneficiaries. To the extent that income is distributed to the beneficiaries, the beneficiaries, not the trust, are subject to tax on that income.
Income distributed to a special needs beneficiary does not usually result in a large tax consequence, because beneficiaries usually have limited taxable income. Often, the special needs beneficiary’s income is below the limit subject to income tax. Even if the beneficiary is subject to income tax, that tax is usually assessed at a low rate (10 or 15 percent).
Tax Complications of SNTs
When the SNT retains trust income, however, special tax rules apply that often result in significantly higher income tax obligations. Under current law, the tax brackets for trusts and estates are compressed, which means that a trust reaches the highest income tax rate (39.6 percent in 2013) once it has $11,950 of income (in 2013).
As noted, most SNT beneficiaries have limited income and often do not exceed the 15 percent tax rate on income distributions they receive from the SNT. Using the 2013 tax tables, a trust will be subject to income tax rates of 25 percent (the next tax bracket over 15 percent) on income over $2,450, while a single individual (for example, the SNT beneficiary) would reach this tax rate only if the beneficiary had income over $36,250.
SNT trustees who do not distribute income to the beneficiary every year will be forced to distribute a sizable portion of trust income to the government in the form of income taxes, reducing the benefits available to the special needs person. To make matters worse, SNTs with undistributed income in excess of $11,950 also will be subject to the 3.8 percent investment income surtax imposed by the Patient Protection and Affordable Care Act of 2010, increasing the total tax rate paid on income over $11,950 to 43.6 percent. Obviously, these high tax rates impose pressure on trustees to make distributions, even when distributions may not be prudent given the unique circumstances of the special needs beneficiary.
Life Insurance Solution
Thankfully, there is a solution to the SNT trustee’s dilemma of either (1) distributing income to the beneficiary when distributions are imprudent, or (2) not distributing income and incurring a high income tax liability on small amounts of trust income. To fix the problem, the invested assets inside of the trust would have to be shielded from current income tax (by being tax-deferred or tax-exempt), while still being available for the trustee to distribute to the special needs person when necessary. Life insurance may be an ideal funding vehicle for SNTs, particularly in light of the 2013 income tax increase and the imposition of the investment income surtax.
For decades, businesses have been funding executive deferred compensation plans with life insurance. Like the case with SNTs, the sponsors of executive deferred compensation plans seek to avoid current income tax on accumulations while retaining access to the underlying investment assets so that distributions can be made as specified in the plan.
As a funding vehicle, life insurance provides tax-deferred growth (or tax-free growth, if the policy is in force at the death of the insured), yet permits the owner either to withdraw funds up to the amount of the basis in the policy, or borrow from the cash value without income tax consequences. Therefore, use of life insurance as the funding vehicle for a SNT relieves the trustee of a significant income tax burden while permitting the trustee access to the cash value to cover the current needs of the beneficiary.
When SNTs are created as inter-vivos trusts, life insurance can be purchased on the life of the grantor, the grantor’s spouse, or as a joint life policy on the couple. During the grantor’s life, many of the beneficiary’s financial needs can be paid for directly by the grantor, thereby allowing the policy cash value inside the trust to accumulate while still being available for use if necessary. Upon the death of the grantor, the trust will receive the death benefit free of federal income tax, potentially magnifying the benefits available to the special needs individual.
If the special needs individual is insurable, an alternative approach is a life insurance policy purchased on the life of the beneficiary. This approach provides tax deferral on the underlying investments while allowing access to those investments for distribution when necessary and replacing the wealth consumed by the special needs beneficiary with a tax-free life insurance death benefit for the remainder beneficiaries of the SNT.
A Final Note
In an era of higher tax rates, life insurance can be an ideal funding vehicle for special needs trusts. Although circumstances will vary, use of a maximum-funded, low-death-benefit variable universal life insurance policy typically will be appropriate, especially when the projected time frame and the grantor’s financial risk tolerance are consistent with equity-based returns.
Regardless of the type of policy, life insurance funding allows SNT grantors to maximize the benefits available to special needs children by depriving the government of high income tax payments from the special needs trust.