If you have a special needs child with a condition such as Autism, Down Syndrome, or Muscular Dystrophy, you know that you must take extra care to secure your child’s financial future in your absence. A typical inheritance for your child is generally not an option for two reasons: (1) the child usually cannot manage money or make prudent financial decisions; and (2) a typical inheritance would disqualify the child from governmental assistance programs such as SSI and Medi-Cal/Medicaid.

The most common estate planning tool parents use to provide for their special needs children is a Special Needs Trust. A Special Needs Trust holds title to property for the benefit of a beneficiary with a disability while protecting the beneficiary’s eligibility for government assistance programs. You select a trustee (or administrator) to manage and use the trust property for your beneficiary’s needs to supplement the beneficiary’s government benefits, all without disqualifying the beneficiary from any government assistance programs.

Unfortunately, this is not the end of the story if you want to leave retirement accounts to a special needs child. Although a traditional Special Needs Trust works well to receive and manage non-taxable assets (such as cash, securities, life insurance and real estate), it has one major drawback when used to receive taxable assets (such as retirement accounts like IRAs, 401Ks and pensions). To understand this drawback, you must first understand what happens when you leave a retirement account to a child.

Any child named as a beneficiary of a retirement account has two options: (1) withdraw all of the funds within 5 years of your death, or (2) rollover the account into an “Inherited IRA” account.

If the child opts to withdraw the funds, he or she must pay income tax on the distributions¹ and will lose any future tax deferral afforded to IRAs.

If the child opts to rollover the account into an Inherited IRA, he or she will have the option to “stretch” the distributions over his or her life expectancy, therefore deferring taxes while allowing the account to grow tax free. For example, a child with a life expectancy of 40 years is only required to withdraw about 1/40^th of the account each year. The remainder of the account balance may stay in the account and continue growing on a tax-free basis.

Most parents prefer their children to rollover the account into an Inherited IRA to take advantage of the stretch option. However, it is not practical to name a special needs child as the beneficiary because he or she may be incapable of managing the account, and the very existence of the account would disqualify the child from governmental support.

You can designate your child’s Special Needs Trust as the beneficiary, and that will protect the funds without disqualifying the child from governmental assistance. However, the IRS will not allow a Special Needs Trust to rollover the account into an Inherited IRA, and therefore not allow a Special Needs Trust to use of the stretch option.

A retirement account payable to a traditional Special Needs Trust must be distributed, and therefore taxed, within 5 years of your death – there is no option to stretch the distributions over your child’s life expectancy.

There is, however, a lesser known trust that lets you have your cake and eat it too! It is called an Accumulation Trust.

If you name an Accumulation Trust that includes special needs trust language as the beneficiary of your retirement accounts, retirement account distributions can be stretched out based on the trust beneficiary’s life expectancy while protecting your beneficiary’s Medi-Cal/Medicaid and SSI eligibility.

The trustee you name in your child’s Accumulation Trust must withdraw a fraction of the retirement account based on your child’s life expectancy, but the trustee may withdraw more if necessary. The trustee can use the withdrawn funds for your child’s needs or simply keep it in the trust. The unwithdrawn portion will continue growing tax-free in the Inherited IRA.

The IRS rules governing Accumulation Trusts require careful consideration and expert drafting. If done properly, an Accumulation Trust is an excellent vehicle to protect your child’s financial future and defer taxes. One drawback to an Accumulation Trust is that it is only suitable for retirement accounts – you will still need a traditional Special Needs Trust for any other assets you wish to leave to your special needs child.

If you have significant retirement assets, we advise you to contact our office to assess whether an Accumulation Trust could benefit your family’s financial future.