Blog Accumulation Trust for Retirement Benefits to Special Needs Beneficiaries

By Cowles Liipfert

Prior to the adoption of The SECURE Act of 2019, the required minimum required distributions (RMDs) for retirement accounts were based strictly on the actuarial life expectancy of the beneficiary. If the beneficiary of the retirement account was a trust, the distributions from the retirement account to the trust were based on the age of the trust’s “identifiable primary beneficiary.” If there were several identifiable beneficiaries, the RMD was based on the life expectancy of the oldest identifiable beneficiary.

The SECURE Act of 2019 changed the required minimum distributions (RMD) for retirement account beneficiaries (including identifiable beneficiaries of trusts) other than spouses, including adult children or grandchildren. The RMD has been changed from their actuarial life expectancy to 10 years (maximum), subject to exceptions. An exception is still available for beneficiaries who are “disabled” as defined by Internal Revenue Code Section 72(m)(7) or “chronically-ill” as described by Code Section 7702B(c)(2), with limited exceptions. The RMD for trusts on behalf of those beneficiaries is still based on the actuarial life expectancy of the identifiable primary beneficiary, and is not subject to the 10-year maximum payout applicable to most beneficiaries.

The Secure Act of 2019 virtually eliminated the “Stretch IRA” strategy to reduce IRA distributions by naming very young beneficiaries, but some of those benefits still exist for disabled or chronically-ill beneficiaries.

Distributions from a retirement account result in taxable income to the beneficiary or beneficiaries who receive the distributions. When a distribution is payable to a trust, the trust receives the taxable income, but the income tax liability for the distribution is passed on to the beneficiaries to whom the trust further distributes the income. Trusts are taxable entities and they file fiduciary income tax returns each year and pay income tax on any undistributed income. However, if distributions to beneficiaries are made during the year (or early in the following year, if the trust so elects on its timely-filed fiduciary income tax return), the trust can claim a “distribution deduction” on its fiduciary income tax return. That is, the trust can deduct from its taxable income the amount distributed to trust beneficiaries, and the trust issues a Schedule K-1 to the trust beneficiaries, reporting the distribution as taxable income to them. The tax laws discourage trust income from being accumulated in a trust by taxing undistributed trust income at much higher rates than the rates applicable to individuals.

The terms of some trusts require that the trusts distribute all their income to trust beneficiaries each year. These trusts are often called “simple trusts,” but insofar as retirement benefits are concerned, this type of trust can be categorized as a “Conduit Trust.”

A Conduit Trust is sometimes called a “see-through” trust, since the retirement distributions are taxable to the trust beneficiaries who end up receiving the distributions, and are not taxable to the trust.

Most of the time, overall income taxes are` reduced if a trust distributes retirement account income to the beneficiaries of a trust – because of the high tax rates applicable to trusts. However, minimizing taxes may not be the only consideration.

If the beneficiary of the IRA is a trust for a special needs beneficiary who is an “identifiable primary beneficiary,” any distributions of retirement account income from the trust to the trust beneficiary might result in too much income for the beneficiary, thereby disqualifying the beneficiary from means-tested governmental benefits, such as Medicaid.

An Accumulation Trust is an alternative to a Conduit Trust. The Accumulation Trust can be named as a beneficiary of retirement account benefits for an identifiable primary beneficiary, instead of a Conduit Trust. If the retirement income is not required to be distributed to the identifiable primary beneficiary and it may instead be retained by the trust, then the retirement account income would not cause the beneficiary to lose means-tested benefits, such as Medicaid. See Reg. Section 1.401(a)(9)-5, Q & A-7(c)(3), Example 1.

Consequently, an Accumulation Trust may be appropriate where the identifiable primary beneficiary of a trust is a special needs individual. The Accumulation Trust allows the trustee to receive the RMD from the retirement account, but does not require the trustee to distribute the RMD to the special needs beneficiary each year, thereby preserving the eligibility of the special needs beneficiary for needs-based government benefits. Instead of distributing the benefits to the beneficiary every year, which is a requirement of a Conduit Trust, the trustee of an Accumulation Trust can retain retirement benefits within the trust for future distributions to the special needs beneficiary or to the remainder beneficiaries of the special needs trust.

An Accumulation Trust which accumulates retirement distributions within the trust and does not distribute those benefits to the beneficiary must pay income tax on the accumulated income at trust tax rates, which are much higher than individual rates. However, even highly-taxed retirement account income which is accumulated within a special needs trust might be preferable to having the trust beneficiary declared ineligible for means-tested benefits, such as Medicare.

That is, if a Special Needs Trust is required to distribute to beneficiaries the required minimum distribution (RMD) from retirement accounts, the distributions would reduce the trust’s taxable income on the trust’s fiduciary income tax return, but would increase the beneficiary’s income. If the trust is an Accumulation Trust and is not required to distribute the income to the special needs beneficiary, the undistributed income is taxable to the trust itself, and it is not deemed to be taxable income of the trust beneficiary; since the income is retained by the trust, it is not considered to be the beneficiary’s income and does not disqualify the beneficiary from means-tested government benefits.

To be a valid Accumulation Trust, (a) the trust must be a valid trust under state law, (b) the trust must be irrevocable, (c) the beneficiaries must be identifiable and (d) certain documentation must be provided to the plan administrator.

As a result, even though the RMD may be taxable to the Accumulation Trust in high income tax brackets, The SECURE Act of 2019 may permit smaller RMDs from a retirement account to a trust for a disabled or chronically-ill beneficiary, in which case the amount required to be distributed to the trust will often be a smaller amount than would be applicable if the beneficiary were not disabled or chronically ill. That is, the tax detriment caused by the high fiduciary income tax rates, may be partially offset by a lower RMD from the retirement account to the trust.

If you currently have named a trust for the benefit of a disabled or chronically-ill trust beneficiary as beneficiary of your retirement account, you should review the terms of the trust with a qualified attorney, to make sure that the trust is not a Conduit Trust, which could render the trust beneficiary ineligible for means-tested government benefits, such as Medicaid.

If you have a retirement account or accounts from which you want to accumulate retirement income in trust for the possible needs of a disabled or chronically-ill beneficiary, you should consider having the retirement account payable to an Accumulation Trust for that beneficiary, instead of a Conduit Trust, which must be paid out at least annually to the beneficiary.