The 2010 Tax Relief Act raised the amount each of us can give away free of federal gift and estate taxes to $5 Million. Even though the new law only provides a two year "fix," most prognosticated think these increased exemptions from estate and gift taxes will be extended and, as a consequence, most individuals will no longer have to be concerned with these taxes. Unfortunately, the Act does not provide comparable income tax relief benefits. As a result, even families of modest means, whose major assets are retirement benefits, cannot cross income tax planning off their "TO DO" list. Plus, families that include an individual with special needs must contend with the convergence of several competing interests--means-tested benefit issues, income tax planning and charitable goals--when developing an estate plan with retirement benefits.
Most retirement benefits (like 401(k) or 403(b) plans and IRAs) grow tax deferred, while held in the account. However, income taxes will be owed when the funds are paid out, regardless of whether paid to the account owner during his or her lifetime or to a special needs trust for a child with disabilities or other beneficiary at the account owner's death. Standard income tax planning involves strategies to stretch out distributions from tax deferred assets to limit income taxes due--strategies that work for beneficiaries who are not on means-tested government benefit programs. For beneficiaries of means-tested government benefit programs, such as SSI, Medicaid and food stamps, trying to combine special needs planning and income tax planning is like mixing oil and water, however. It is very hard to do.
In almost all cases, a retirement plan inherited outright by a person with disabilities will be treated as an available asset or as monthly income that will reduce or eliminate means-tested government benefits. But naming an individual as the designated beneficiary of a tax deferred retirement plan is the best way, from an income tax planning perspective, to spread distributions over time and limit income taxes. What should a retirement plan owner do?
When the owner of a retirement plan dies, special rules mandate at what rate an inherited retirement account must be paid out to the beneficiary. These complicated rules about inherited retirement plans make planning with them particularly challenging when the beneficiary receives means-tested public benefits. These special rules include:
* Retirement funds left directly to an individual may be stretched out over the beneficiary's life expectancy to preserve some of the income tax benefits offered by the retirement account. This is attractive from an income tax perspective, but this is not an option for a beneficiary receiving means-tested benefits because direct receipt of the funds will usually disqualify the person from receiving benefits.
* If retirement funds are left to a trust for the benefit of a beneficiary, the favorable tax treatment can be preserved if the trust provides that all of the retirement account's annual required minimum distribution is to be paid out to the beneficiary of the trust each year. A trust with this provision is sometimes referred to as a "conduit trust." Unfortunately, including a conduit provision in the trust causes eligibility problems for means-tested benefits because of the mandatory distributions to the beneficiary. SSI will likely be reduced by the amount of the distribution or even lost entirely if the distribution amount exceeds the SSI payment.
* Because a special needs trust is a discretionary trust, not a conduit trust, another subset of rules applies. The most important rule in this subset states that the age of the oldest trust beneficiary at the account owner's death, whether the special needs beneficiary or any contingent beneficiary, will be the measuring life for determining the rate at which retirement funds must be distributed to the trust and, therefore, taxed. …