IRAs and special-needs trusts

In a recent private-letter ruling (PLR 201116005), the Internal Revenue Service allowed a disabled beneficiary to transfer his share of two inherited individual retirement accounts to a special-needs trust of which he was the beneficiary.

The IRS reasoned that because the beneficiary would still be considered the owner of the assets under grantor trust rules, the transfer wouldn’t trigger income tax.

But even though the IRS ruled similarly in an earlier private-letter ruling about disabled beneficiaries, poor planning carried a cost: the expense of the ruling itself plus the loss of all or a portion of the remaining inherited IRA assets upon the death of the disabled beneficiaries.

Thankfully, not every client will have to deal with special-needs issues. But nearly every financial adviser will at some point or another.

Let’s look at a typical case.

“Bob,” a disabled person, was one of several beneficiaries of his father’s IRA accounts. At the time of his father’s death, Bob and his siblings were the designated beneficiaries — that is, they were personally named on the beneficiary form — of two IRAs.

As a disabled individual, Bob is, or may be, eligible for certain needs-based assistance programs, such as Medicaid. In order to preserve those benefits, he didn’t want to be the direct beneficiary of the inherited retirement accounts.

Instead, Bob proposed that his share of his father’s inherited IRAs be transferred to a special-needs trust for his benefit, fully aware that the inherited account would be set up as a properly titled inherited IRA benefiting the trust.

[More: Can a trust transfer an IRA to a trust beneficiary?]

SOLE BENEFICIARY

Bob’s special-needs trust was drafted with him as the trust’s sole beneficiary during his lifetime. Like many special-needs trusts, its provisions would allow the trustee to use his or her sole discretion to determine how much of the trust’s income and, if necessary, principal would be available for Bob’s benefit.

The trust terms would, however, prevent any distributions to Bob that would reduce or eliminate any governmental assistance to which he were entitled.

At his death, any remaining trust assets would first be distributed to the state as repayment for his benefits, and any excess would then pass to Bob’s children or, if there were none, to his siblings. Bob most likely didn’t want the remaining assets to go to the state, but because this proposed transfer was being done after the IRA owner’s death, as opposed to his father’s naming the trust as the beneficiary in the first place, Bob really had no choice in the matter.

In Bob’s case, the IRS ruled favorably. Because Bob always would be treated as the owner of the trust property, including the inherited IRA, the IRS concluded that the transfer would neither trigger a taxable event nor be considered a gift to the trust.

However, Bob’s father’s failure to plan properly ended up costing Bob and his family big-time in the form of considerable fees connected with the private-letter ruling and the potential of trust assets’ going back to the state after Bob’s death.

Bob’s father could have named the trust as the beneficiary of Bob’s share of the IRA, and there would be no need to request a costly private-letter ruling after death.

Had Bob’s father left Bob’s portion of his IRAs to a special-needs trust for Bob’s benefit by creating a third-party trust, rather than going to Bob directly, he could have helped to preserve far more of his IRA for future generations.

The IRS rulings in these cases raise the issue of whether the principle of transferring retirement funds to a grantor trust 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 seemingly inconsistent, appears to be no.

This position, taken repeatedly by the IRS, was reaffirmed in a private-letter ruling released April 29.

Although the planning process for a disabled beneficiary is often cumbersome, the good news is that there is usually ample time to do so. Often, it is clear early on in an individual’s life that a mental or physical disability will create a need for governmental assistance.

In other situations, an accident or illness later in life may create the same need. In such cases, a little planning before death can go a long way to make sure that a client’s wishes are fulfilled once they are gone.

Ed Slott, a certified public accountant, created the IRA Leadership Program and Ed Slott’s Elite IRA Advisor Group to help financial advisers and insurance companies become recognized leaders in the IRA marketplace. He can be reached at irahelp.com