Many individuals engaging in estate planning opt to create a third-party special needs trust to provide for their loved one living with a disability. However, did you know that these trusts may have to pay taxes on any income generated from the trust assets and retained by the trust for future use? If the trust is a qualified disability trust (QDT), it can minimize unnecessary tax consequences.
What Type of Trust Qualifies?
To qualify as a qualified disability trust, a trust must meet the following basic requirements:
- It must be irrevocable.
- The beneficiaries must be disabled and receive Supplemental Security Income (SSI) or Social Security Disability Insurance (SSDI). Additionally, the trust must have been established for their benefit before they turn 65.
- It cannot be a grantor trust and must be a separate tax-paying entity. So, for example, a first-party or self-settled special needs trust cannot qualify.
- Any remaining amount in the trust may be transferrable to nondisabled beneficiaries once the disabled beneficiaries are deceased.
Why Become a Qualified Disability Trust?
If a trust meets these requirements, it can reap significant tax benefits. Without the qualified disability trust designation, a trust normally may exempt up to $100 to $300 of income it generates from taxation, depending on whether it is required to distribute all of its income. However, a QDT may take an exemption equal to what an individual filing a personal income tax return may take. Per the Internal Revenue Code, this is $4,150 plus an annual adjustment for inflation.
In addition to the exemption, an individual benefits from more favorable tax brackets on income than a trust. A qualified disability trust also gets this benefit. As of 2022, the highest income trust bracket for a trust applies to amounts over $13,450, and the highest tax rate for trusts is 37 percent. In contrast, an individual taxpayer is not taxed at the highest rate of 37 percent until his or her income reaches $539,900 or more.
This preferred tax treatment can make a difference, especially when a trust wishes to retain income for future use. Alternatively, a trust may not want to distribute all income in order to protect beneficiaries from being disqualified from means-tested benefits such as Medicaid or SSI. Paying fewer taxes on retained income means more is left over for beneficiaries.
A qualified disability trust will have to file a tax form called Form 1041 to receive these benefits every year. A trust may need the assistance of a tax professional. However, this expense is well worth it when you consider the potential tax savings.
Estate Planning Tips
If you are setting up a special needs trust through your will, a best practice tip is to avoid vague terms and specifically name the beneficiary of the anticipated QDT. This will allow them to elect the qualified disability trust treatment on appropriate tax forms.
You should also carefully select your trustee. A trustee of a qualified disability trust will have serious fiduciary responsibilities that can last a lifetime. They should be financially savvy and willing to invest time and resources in correctly maintaining and administering a QDT. This includes keeping up with all annual tax filings. Elville and Associates’ and its Managing Principal, Stephen R. Elville, offers a quarterly webinar presentation titled “Trustee Selection – How to Choose the Right One for You,” which discusses this important topic in depth. You can view this presentation here.
By engaging in proper planning when setting up a special needs trust for your loved ones, you are setting them up for a better and brighter future. Working with an attorney to set up your trust correctly to qualify for qualified disability trust status may make an immeasurable difference in the lives of your beneficiaries.
For guidance in estate and special needs planning, consult with the qualified attorneys at Elville and Associates. Initial consultations are free and will give you the opportunity to have your questions answered, have your attorney listen to you and understand your situation, and offer you solutions and a path forward for your planning, giving you peace of mind along the way. Contact us online here or call us at 443-393-7696 to get started today.