As advances in medicine continue, it's become more likely that special- needs children may outlive their parents. For example, the average life expectancy of a person with Down syndrome is 60 today, compared with only 25 in 1983, according to the National Down Syndrome Society.

Yet many families remain unprepared. Two-thirds of parents with special-needs children have not prepared wills, according to a study by MetLife of more than 1,700 parents. Nearly one-third have done nothing at all to plan for their child's financial future.

Knowledgeable planning is essential to maximize the money available to special-needs beneficiaries after their parents' deaths. Poor planning can be costly. For example, in a recent private letter ruling (PLR 201116005), the IRS considered whether to allow a disabled beneficiary to transfer his share of two inherited IRAs to a special-needs trust, of which he was the named beneficiary.

Advisors can learn from this ruling and help families with special-needs beneficiaries preserve assets, and reduce unnecessary costs and losses. While not every client will have to deal with special-needs issues, nearly every advisor will.

THE FACTS

Consider the case of the disabled man, who was one of several beneficiaries of his father's IRA accounts. Because of his disability, the man was eligible-or potentially could be-for certain assistance programs, such as Medicaid. In order to preserve those benefits, the man did not want to be the direct beneficiary of the inherited retirement accounts.

Instead, he proposed that his share of the inherited IRAs be transferred to a special-needs trust for his benefit. The inherited account would be set up as a properly titled inherited IRA benefiting the trust.

The man would be named as the trust's sole beneficiary during his lifetime. Like many special-needs trusts, this trust's provisions would allow the trustee to use his discretion to determine how much of the income and, if necessary, principal would be available for the man's benefit. The trust terms would, however, prevent any distributions that would reduce or eliminate any governmental assistance to which he was otherwise entitled.

At the man's death, any remaining trust assets would first be distributed to the state as repayment for his benefits, and any excess would then pass to his children; if he had no kids, then to his siblings. Most likely, the man would not want the remaining assets to go to the state, but since this proposed transfer was being done after the IRA owner's death (his father had not named the trust as the beneficiary), he had no choice.

To determine with certainty the tax effects of this transaction, the man' representatives asked the IRS to issue a private letter ruling that would continue to treat him as the owner of the trust's assets and therefore not trigger any income tax on the transfer of the inherited IRA to the special-needs trust, nor be considered a gift to the trust. The IRS ruled favorably in this case, as it did in two other similar private letter rulings (PLRs 200620025 and 200826008), citing a 1985 IRS revenue ruling. However, the father's failure to plan properly carried a severe cost.

NO STRATEGY SUBSTITUTE

For starters, this post-death transfer is still far from an established planning strategy. And requests for private rulings are expensive. This one cost $10,000-and that's just the IRS fee. Preparation could easily run as much, if not more. Alternatively, and relatively easily, the dad could have named the trust as the beneficiary of this son's share of the IRA.

There are two categories of special-needs trusts: first-party trusts and third-party trusts. Trusts funded by the beneficiary's own assets, such as the one described in this IRS ruling, are first-party trusts.

They can be used to help individuals with special needs reduce their total assets and income to qualify for Medicaid and other benefits but, upon the death of the grantor or beneficiary, any remaining trust assets must first be used to repay the state for any benefits that were provided. The trust in this case is a first-party trust because the IRA beneficiary was the son, not the special-needs trust.

Third-party special-needs trusts are funded with assets belonging to someone other than the individual with special needs, such as the beneficiary's parents. In such trusts, all remaining assets can pass to remainder beneficiaries once the special- needs person dies.

There is no requirement to repay the state for any benefits received. Had the father left this son's portion of his IRAs to a special-needs trust for his benefit (creating a third-party trust) instead of to him directly, he could have preserved far more of his IRA for future generations.