Special Needs Trusts: Planning for Disabled Beneficiaries

When you have a loved one with a disability, estate planning takes on added complexity. You want to ensure that they are cared for after you’re gone, but leaving assets outright can jeopardize their eligibility for government benefits. A special needs trust (SNT) — sometimes called a supplemental needs trust — is a powerful tool that allows you to provide for a beneficiary with a disability without disrupting needs‑based benefits like Supplemental Security Income (SSI) or Medicaid. This guide explains how special needs trusts work, the different types available, and how to fund and manage them effectively.

Why Special Needs Trusts Are Needed

Many public benefits that support individuals with disabilities — SSI, Medicaid, Section 8 housing, and certain state programs — have strict income and asset limits. For example, to qualify for SSI, an individual generally cannot have more than a small amount of countable resources (often around $2,000). If you leave an inheritance directly to a person receiving SSI, they may lose benefits until the inheritance is spent down.

A special needs trust allows assets to be held and used for the beneficiary without being counted as their personal resources. The trust can pay for expenses that enhance quality of life — such as education, therapies, travel, and recreation — while the beneficiary continues to receive government assistance for basic support.

Types of Special Needs Trusts

There are three primary categories of special needs trusts. The right type depends on whose money funds the trust and the specific goals involved.

Third‑Party Special Needs Trust

A third‑party SNT is created by someone other than the beneficiary (typically parents or grandparents) and funded with their assets, not the beneficiary’s. Since the money never belonged to the beneficiary, it is not subject to Medicaid repayment when the beneficiary dies. Any remaining funds can go to other family members or charities.

Example: Emma and Mark have a son, Josh, who has autism. They establish a third‑party special needs trust and name themselves as the grantors. They fund the trust with life insurance and investment accounts. After Josh’s lifetime, any remaining assets will pass to his siblings. Because the trust was funded with Emma and Mark’s resources, Medicaid cannot claim the balance.

First‑Party (Self‑Settled) Special Needs Trust

A first‑party SNT is funded with the beneficiary’s own assets, such as an inheritance, personal injury settlement, or savings. Under federal law (42 U.S.C. § 1396p(d)(4)(A)), the trust must be irrevocable, the beneficiary must be under 65 at the time of funding, and the trust must contain a Medicaid payback provision. When the beneficiary dies, any remaining trust assets must reimburse the state for Medicaid benefits received.

Example: Alex was injured in a car accident and received a settlement. To preserve his SSI and Medicaid, his attorney creates a first‑party special needs trust and transfers the settlement proceeds into it. The trust pays for Alex’s therapy and adaptive equipment. Upon Alex’s death, any remaining funds must repay Medicaid.

Pooled Special Needs Trust

A pooled trust is managed by a non‑profit organization that pools and invests funds from many beneficiaries. Each beneficiary has a separate account, and the trustee uses economies of scale to reduce administrative costs. Pooled trusts can be funded with first‑party or third‑party assets. In a first‑party pooled trust, Medicaid payback applies, but any residual may go to the non‑profit’s charitable mission.

Example: Luisa, who has an intellectual disability, has no family members able to serve as trustee. She joins a pooled trust administered by a local non‑profit. The organization manages her funds professionally and distributes money for items not covered by benefits. Upon her death, a portion of her remaining account reimburses Medicaid and the rest supports the non‑profit’s programs.

Key Components of a Special Needs Trust

Creating an effective special needs trust involves careful drafting and management. Important elements include:

• Trustee: The person or institution responsible for managing the trust, investing assets, and approving distributions. Trustees must understand government benefit rules and fiduciary duties.

• Beneficiary: The individual with a disability who receives supplemental benefits from the trust. The trust should describe the beneficiary’s disability and eligibility for public assistance.

• Grantor (or Settlor): The person who creates and funds the trust. In a third‑party SNT, the grantor is typically a parent or grandparent; in a first‑party SNT, it is the beneficiary or their guardian.

• Discretionary Distributions: To preserve government benefits, distributions must be at the trustee’s discretion. The beneficiary cannot have the power to demand distributions or control the trust assets.

• Supplemental Purpose: The trust document should state that the trust is intended to supplement, not supplant, public benefits. Payments should not be made for food or shelter if the beneficiary is on SSI, as those categories are considered “in‑kind support and maintenance” and may reduce benefits.

• Remainder Beneficiaries: For third‑party trusts, designate who receives any remaining assets after the beneficiary’s death (e.g., siblings or charity). First‑party trusts require a Medicaid payback before funds pass to others.

Funding a Special Needs Trust

You can fund a special needs trust during your lifetime, at death, or both. Funding sources may include:

• Life insurance: A common strategy is to purchase a life insurance policy naming the SNT as beneficiary. This ensures funds are available to support your loved one after your death.

• Savings and investments: Parents and grandparents can transfer stocks, bonds, or real estate into the trust. Assets transferred during life remove future appreciation from your estate.

• Retirement accounts: Leaving retirement assets to an SNT requires careful coordination because distributions will be taxed. A trust must meet “see‑through” requirements to stretch distributions.

• Gifts from family members: Encourage relatives to contribute to the trust instead of giving gifts directly to the beneficiary.

• Inheritance or legal settlements: If the beneficiary receives an inheritance or settlement, a first‑party SNT can preserve benefits.

If funding during life, remember to transfer title properly and adhere to any state laws regarding transfers. When funding at death, coordinate your will, trust, and beneficiary designations to ensure assets flow into the SNT.

Choosing a Trustee

The trustee plays a crucial role in administering the trust. Consider:

• Knowledge of benefits programs: Trustees must understand SSI and Medicaid rules, as improper distributions can jeopardize benefits.

• Financial competence: Managing investments, paying bills, and keeping records requires skill. A professional trustee (bank, trust company, or non‑profit) can be helpful for larger trusts.

• Availability and longevity: Family members may be caring and cost‑effective but might not be available long term. Naming a successor trustee ensures continuity.

• Compensation: Trustees are entitled to reasonable compensation. Include language about fees and reimbursement for expenses.

Many families choose co‑trustees — for example, a parent serving alongside a professional fiduciary — to balance personal knowledge of the beneficiary with professional oversight. If no family or friend is appropriate, a pooled trust can provide professional management.

Administration and Distributions

Proper administration is essential to maintain benefit eligibility:

• Distributions must be discretionary. The trustee should have complete control over when and how funds are spent. The beneficiary cannot receive cash directly.

• Avoid paying for food or shelter if the beneficiary receives SSI, as these payments count as in‑kind support and may reduce the monthly benefit. Trust funds can be used for anything else that improves quality of life — medical and dental care not covered by insurance, education, vehicles, vacations, entertainment, hobbies, and adaptive equipment.

• Keep thorough records. The trustee should retain receipts and document reasons for distributions in case of government audits.

• Coordinate with benefit programs. Inform Social Security and Medicaid agencies about the trust and comply with reporting requirements.

Case Study: Maria is trustee of her adult son Ben’s special needs trust. Ben receives SSI and Medicaid. The trust pays for his music lessons, therapy dog expenses, and a trip to see his favorite baseball team. Maria always pays vendors directly rather than giving Ben cash. She keeps receipts and submits annual reports to Social Security to confirm that distributions are for supplemental purposes.

Letters of Intent and Life Planning

In addition to the formal trust document, parents and caregivers often prepare a letter of intent (also called a memorandum of intent). This non‑binding document provides guidance to future caregivers and trustees about the beneficiary’s daily routine, likes and dislikes, medical needs, and aspirations. It can cover:

• A description of the disability and any diagnoses

• Current living arrangements and future housing preferences

• Educational and therapeutic programs

• Social and recreational activities

• Religious and cultural traditions

• Names and contact information for doctors, therapists, and service providers

• Personal routines, habits, and preferences

Although not legally binding, a well‑written letter of intent helps ensure that the beneficiary’s quality of life is maintained.

Coordination with ABLE Accounts

Achieving a Better Life Experience (ABLE) accounts allow individuals with disabilities to save for disability‑related expenses without losing eligibility for SSI or Medicaid. Created under federal law, ABLE accounts are available to individuals whose disability began before age 26. Contributions are limited annually (similar to the annual gift tax exclusion), and the account grows tax‑free.

Special needs trusts and ABLE accounts can complement each other. For example, parents might fund a third‑party SNT for large inheritances while the beneficiary uses an ABLE account for day‑to‑day spending. ABLE funds can cover housing and food expenses without reducing SSI benefits if used in the same month they’re withdrawn. Work with an attorney or benefits advisor to coordinate these tools effectively.

Tax Considerations

Special needs trusts are generally treated as grantor trusts during the grantor’s lifetime if created by a parent for a child. Income is reported on the grantor’s personal return. After the grantor’s death, the trust becomes a separate tax entity and may need to file its own Form 1041. First‑party trusts are usually taxed as non‑grantor trusts, meaning trust income is reported at the trust level unless distributed to or for the benefit of the beneficiary.

Because trusts reach the highest tax bracket at low levels of income, investing in tax‑efficient vehicles and distributing income when appropriate can help reduce taxes. Consult a tax professional to determine the best strategy.

Common Mistakes to Avoid

1. Naming the beneficiary outright on accounts. Leaving retirement accounts, life insurance, or other assets directly to a beneficiary receiving SSI or Medicaid can cause disqualification. Name the SNT instead.

2. Failing to include a Medicaid payback clause in a first‑party trust. Without required language, the trust may be considered an available resource.

3. Making improper distributions. Giving cash to the beneficiary or paying for food or housing can reduce benefits. Educate all trustees on permissible expenditures.

4. Not updating the trust for law changes. Government benefits rules and tax laws evolve. Regularly review the trust with an attorney.

5. Naming the wrong trustee. Trustees must be knowledgeable about benefits and reliable. Don’t assume a relative will handle everything correctly without guidance.

Frequently Asked Questions

Can my child still receive SSI if they have a special needs trust? Yes, if the trust is drafted and administered correctly. The trust assets are not counted against resource limits as long as distributions are discretionary and supplemental.

What expenses can a special needs trust pay for? Almost anything that enhances the beneficiary’s quality of life except food and shelter when the beneficiary receives SSI. Acceptable expenses include medical costs not covered by insurance, therapies, education, entertainment, vacations, computer equipment, and transportation.

Do I need a lawyer to set up a special needs trust? Yes. Special needs trust law is complex, and mistakes can jeopardize benefits. An attorney can ensure compliance with federal and state requirements, draft appropriate terms, and help you fund the trust.

What happens to the money after my child dies? In a third‑party SNT, remaining assets can pass to other family members or charities. In a first‑party SNT, remaining funds must first reimburse Medicaid for benefits paid to the beneficiary; any leftover balance can then go to designated remainder beneficiaries.

Can other relatives contribute to the trust? Yes. Family members and friends can gift money or leave inheritances to the trust. They should be informed about the trust so they don’t inadvertently give assets directly to the beneficiary.

Conclusion

Special needs trusts are vital tools for families who want to provide for loved ones with disabilities without jeopardizing means‑tested benefits. By understanding the types of special needs trusts, carefully selecting trustees, funding the trust appropriately, and adhering to benefit rules, you can ensure that your beneficiary enjoys a high quality of life now and in the future. Work with experienced attorneys and advisors to build a plan that integrates the trust with other estate planning strategies, including ABLE accounts, life insurance, and tax planning. Planning today brings peace of mind, knowing your loved one will be cared for when you’re no longer able to provide support yourself.