Investments for Special Needs Trust

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Topic Author
Toph
Posts: 5
Joined: Mon Jan 11, 2021 12:06 pm

Investments for Special Needs Trust

Post by Toph »

Hello Everyone,
I’m new here and am seeking advice for building a portfolio for a trust. My dad passed away 4 months ago and left me as trustee. The purpose of the trust is to provide a safety net for my physically disabled sister and it has rules specific to a Special Needs Trust. I cannot make distributions directly to her and can only use funds to pay her bills (payment directly to the account owed).

She is the only primary beneficiary and me and my siblings are secondary beneficiaries and will inherit what remains after she passes. With the exception of the mortgage, she is financially independent. I plan to pay off the mortgage (owned by the trust), but after that the remaining money (about 300k) will mostly sit until she passes, and then will be distributed to secondary beneficiaries.

She has a shorter than normal life expectancy and has already surpassed doctors expectations. It is impossible to anticipate how many years she has remaining.

Trust tax brackets are compressed:
* $0 to $2,600 in income: 10% of taxable income
* $2,601 to $9,450 in income: $260 plus 24% of the amount over $2,600
* $9,450 to $12,950 in income: $1,904 plus 35% of the amount over $9,450
* Over $12,950 in income: $3,129 plus 37% of the amount over $12,9504

Most trusts distribute the investment income and the tax is passed to the beneficiary to pay in their own (usually lower) tax bracket. But as a special needs trust, I cannot make distributions. And even if I could, it would not serve the best interests of the secondary beneficiaries. And, of course, all trust investment accounts are taxable.

If taxes weren’t a consideration, I’d go for the usual three fund portfolio with 20/80 or 30/70 (stocks/bonds) as I expect the investment time won’t be long enough to justify anything more aggressive than that, but bonds will for sure shoot the trust into the top tier 37% tax rate.

Any suggestions on how to build a conservative portfolio that won’t be eaten up by taxes?

I have been researching muni bonds, but feel unsure about them presently. I would love to hear thoughts on muni bonds as well as other ideas and alternatives for conservative investments.

Thank you for taking time to post and share.
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dmcmahon
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Re: Investments for Special Needs Trust

Post by dmcmahon »

With an asset base of $300k, even if you put it 100% into stocks yielding about 2% in dividends, that’s $6k per year. Roughly half of that would be in the 24% tax bracket. I would say taxes are a low priority. Paying off the mortgage is a smart move, if she has a life estate in the home. It buries some cash without an income and tax penalty.
MtnBiker
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Joined: Sun Nov 16, 2014 4:43 pm

Re: Investments for Special Needs Trust

Post by MtnBiker »

I'm just trying to learn about Special Needs Trusts too. I read on another thread that if trustees invest mainly for qualified dividends, tax-exempt income and long-term capital gains, and don’t do much trading, there won’t be much tax for the trust to pay.

Is the primary beneficiary presently receiving any government benefits? If so, does the trust meet the definition of a Qualified Disability Trust? My understanding is that such a trust can claim a tax exemption on retained income up to $4,200 (2019 value).
bsteiner
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Location: NYC/NJ/FL

Re: Investments for Special Needs Trust

Post by bsteiner »

MtnBiker wrote: Mon Jan 11, 2021 6:27 pm I'm just trying to learn about Special Needs Trusts too. I read on another thread that if trustees invest mainly for qualified dividends, tax-exempt income and long-term capital gains, and don’t do much trading, there won’t be much tax for the trust to pay.
...
That's the case for trusts generally. Unless the trust receives retirement benefits, income taxes aren't usually a major factor.
Topic Author
Toph
Posts: 5
Joined: Mon Jan 11, 2021 12:06 pm

Re: Investments for Special Needs Trust

Post by Toph »

dmcmahon wrote: Mon Jan 11, 2021 6:10 pm With an asset base of $300k, even if you put it 100% into stocks yielding about 2% in dividends, that’s $6k per year. Roughly half of that would be in the 24% tax bracket. I would say taxes are a low priority. Paying off the mortgage is a smart move, if she has a life estate in the home. It buries some cash without an income and tax penalty.
I’ve gotta be honest, I thought no one would reply, because a special needs trust is such a niche topic. Thank you for your responses.

It’s good to be reassured on the decision to pay off the mortgage. I waffled on that decision for awhile, but came to the same conclusions you did.

As for the tax issue, I don’t fear creating a tax drain with stock investments and have decided to invest 20-30% in VTI. The bond investments are what’s causing me consternation. As far as I can see, the only viable option for bonds in a taxable account (made even worse with the compressed tax brackets) would be muni bonds. I’ve done research on VTEB and similar muni ETFs, but am hesitant to commit.

For a little more background, I am new to investing. I have vigorously researched John Bogle and the Boglehead investment principles and plan to follow these principles closely, but have zero experience implementing it. I have a bit of “a deer in the headlights” thing going on with this trust and it’s investment possibilities.

Any feedback on muni ETFs or other tax efficient funds would be appreciated.
Topic Author
Toph
Posts: 5
Joined: Mon Jan 11, 2021 12:06 pm

Re: Investments for Special Needs Trust

Post by Toph »

MtnBiker wrote: Mon Jan 11, 2021 6:27 pm I'm just trying to learn about Special Needs Trusts too. I read on another thread that if trustees invest mainly for qualified dividends, tax-exempt income and long-term capital gains, and don’t do much trading, there won’t be much tax for the trust to pay.

Is the primary beneficiary presently receiving any government benefits? If so, does the trust meet the definition of a Qualified Disability Trust? My understanding is that such a trust can claim a tax exemption on retained income up to $4,200 (2019 value).
My understanding regarding your comments on trust investments is the same. I have wondered if using only 100% qualified dividends in all the investments would keep the trust at $0.00 ordinary income and therefore keep the trust at 0% for capital gains. I’m still trying to wrap my head around how taxes work in relation to investing. I’ll be getting in touch with my accountant soon to get the straight facts.

Yes, my sister receives state Medicaid benefits. I haven’t heard of the tax exemption you referred to. I’ll add that to my list of questions for the accountant.

It’s a lot of pressure to get things set up just right when it’s money that belongs to a family trust rather than just my own money.
JBTX
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Re: Investments for Special Needs Trust

Post by JBTX »

Was she disabled before age 26? A 529 Able may be a useful supplement and have more flexibility . Downside is anything in it could be subject to Medicaid recovery when beneficiary passes away.
MtnBiker
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Re: Investments for Special Needs Trust

Post by MtnBiker »

Toph wrote: Wed Jan 13, 2021 4:53 pm
Yes, my sister receives state Medicaid benefits. I haven’t heard of the tax exemption you referred to. I’ll add that to my list of questions for the accountant.
A google search found a number of websites providing information regarding Qualified Disability Trusts. Here is one example: https://www.specialneedsalliance.org/th ... opriate-2/

The above link states that the person must be considered to be disabled pursuant to the criteria set forth by the Social Security Act. That condition is most easily met if the person is actually receiving Supplemental Security Income or Social Security Disability Insurance benefits, but perhaps could also be satisfied in other ways if needed.
MtnBiker
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Joined: Sun Nov 16, 2014 4:43 pm

Re: Investments for Special Needs Trust

Post by MtnBiker »

Toph wrote: Wed Jan 13, 2021 4:53 pm I have wondered if using only 100% qualified dividends in all the investments would keep the trust at $0.00 ordinary income and therefore keep the trust at 0% for capital gains.
This is an excellent question. I found the following online:
Individuals also enjoy a substantial benefit over trusts when it comes to the income taxation of capital gains and qualified dividends. A trust may only have up to $2,650 (in 2019) of taxable income and still be taxed at 0% on its capital gains and qualified dividends. The comparable level for single individuals is almost 15 times higher, at $39,375 (in 2019), which, when combined with the single beneficiary's $12,200 standard deduction, means that a single individual (including a minor child) could have up to $51,575 in qualified dividends annually without paying any federal income tax. A trust with a like amount of qualified dividend income, on the other hand, would pay approximately $10,750 in income tax (applying 2018 rates), including approximately $1,500 in net investment income tax.
https://www.thetaxadviser.com/newslette ... -tcja.html

So what are the options if retaining income within the trust is undesirable from a trust tax standpoint? Income can be disbursed for spending on whatever may improve the beneficiary's quality of life, while maintaining the beneficiary’s personal assets below any Medicaid asset limit. Distributed trust income is then taxed at the lower tax rate of the individual.

It is my understanding that taxable income from a SNT is not “countable” income for purposes of Medicaid benefits. As you stated, payments should not be made direct to the beneficiary. If the beneficiary is eligible for an ABLE account, funds intended to be available for the beneficiary’s use could be funneled through an ABLE account. (Subject to the annual contribution limit for an ABLE account which is 15K.) This can provide a buffer where excess funds are accumulated in a year when SNT distributable net income exceeds spending for the beneficiary's care and vice versa. (My understanding is that ABLE account funding up to the account limits (typically 300K-529K) does not affect Medicaid eligibility.)

You, as trustee, should be aware that government agencies may get a “tracer” report from the IRS about beneficiary income, and may issue preliminary notices that benefits will be terminated unless they receive proof that the beneficiary did not have countable income. The trustee should be prepared to explain that although the income was reportable to the IRS as the beneficiary’s income for tax purposes, the beneficiary only received distributions “in kind” which is not counted as income for purposes of Medicaid.

See: https://www.specialneedsalliance.org/th ... -trusts-2/
humblecoder
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Joined: Thu Aug 06, 2020 8:46 am

Re: Investments for Special Needs Trust

Post by humblecoder »

Toph wrote: Mon Jan 11, 2021 2:02 pm Hello Everyone,
I’m new here and am seeking advice for building a portfolio for a trust. My dad passed away 4 months ago and left me as trustee. The purpose of the trust is to provide a safety net for my physically disabled sister and it has rules specific to a Special Needs Trust. I cannot make distributions directly to her and can only use funds to pay her bills (payment directly to the account owed).

.....

Most trusts distribute the investment income and the tax is passed to the beneficiary to pay in their own (usually lower) tax bracket. But as a special needs trust, I cannot make distributions. And even if I could, it would not serve the best interests of the secondary beneficiaries. And, of course, all trust investment accounts are taxable.

I am a co-trustee with my wife of a special needs trust for my daughter. Right now, we have a very small amount in it, since she is a minor and we support her like we would support any other child. However, in the future, there may be a non-trivial amount in the trust.

You mention that you use the trust to pay bills on your sister's behalf, but you say that this doesn't count as a "distribution" to her. I am a little confused by that. I would think that even if the money isn't passing through your sister's bank account, it would still be considered a distribution since the trust is making a payment on her behalf. Thus, any investment income in the trust would still be offset by the distribution and thus would end up getting taxed at your sister's individual rate.

Am I missing something or is a distribution truly defined as a direct payment, as opposed to an indirect payment?

The reason why I ask is that this is the first time I have heard this, so I want to clarify my understanding, since I may be in the same situation as you in the future. If you have a reference to an article or something, that would be very helpful.

Don't take this the wrong way. My intent is not to challenge what you are saying as you may be 100% correct. I am just trying to educate myself better. Thanks in advance! :beer
Topic Author
Toph
Posts: 5
Joined: Mon Jan 11, 2021 12:06 pm

Re: Investments for Special Needs Trust

Post by Toph »

humblecoder, no offense taken at all. Pretty much everything I say needs to be taken with a grain of salt anyway, because this is all new to me and I have had minimal guidance from a lawyer.

The second quote you highlighted was just poorly worded and should have said, ‘As a special needs trust, I can’t make distributions directly to her.’ As trustee, I have to be able to prove that the beneficiary has no control or direct access to the funds or she could become disqualified from her Medicaid benefits.

As far as whether the funds used to pay for bills counts as a distribution, yes, it does. But I am in a situation where very few distributions, if any, will be needed. So I don’t have as much opportunity to distribute funds just to lower the income for taxes.

My sister does not receive SSI, only state Medicaid benefits through a buy-in program offered in our state. So her situation is atypical from most who receive special needs benefits.
Topic Author
Toph
Posts: 5
Joined: Mon Jan 11, 2021 12:06 pm

Re: Investments for Special Needs Trust

Post by Toph »

Mtnbiker and JBTX, thanks for the info about ABLE accounts. I will have to take time to consider all the information in the links provided by Mtnbiker. For now, I’m going to go ahead and invest, focusing on ETFs with 100% QDI and in the meantime start researching these tax issues more in depth. I’m only going to invest a portion of the funds until I get a better feel for things.
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