Executive Summary
Planning for special needs beneficiaries is highly complex, a mixture of making challenging care decisions and managing limited resources. Many families will try to save assets on behalf of a special needs beneficiary to provide further support, but if not coordinated properly, can actually disqualify the beneficiary from Federal and state aid programs, including SSI and Medicaid.
The primary solution – establishing a (third-party) supplemental special needs trust – can help preserve the beneficiary’s eligibility for aid programs, but itself has a non-trivial cost to create and maintain, in terms of both legal fees, administrative expenses, and potentially unfavorable tax treatment.
To help ease the challenge for families with special needs children, the recently passed “tax extenders” legislation at the end of 2014 created a new type of account for the supplemental needs of special needs (disabled) beneficiaries. Under the new IRC Section 529A, Qualified ABLE programs will allow families to accumulate funds for such beneficiaries, enjoy tax-free growth, and allow the assets to (mostly) avoid disqualifying the beneficiary from any state or Federal aid, but without the cost and hassle of creating a special needs trust.
Given the limitations of these new 529 ABLE accounts – from restrictions on the size of contributions, to a rather “unfavorable” Medicaid payback provision after the death of the disabled beneficiary – the new Section 529A plans will not likely replace all special needs trusts, but could be used effectively as a supplement to them, and may be an especially appealing alternative to trusts for “smaller” account balances under $100,000.
Section 529A Qualified ABLE Account Rules For Special Needs Beneficiaries
As a part of the “tax extenders” legislation passed at the end of 2014, Congress also passed the Achieving a Better Life Experience (ABLE) Act of 2014. Using the existing Section 529 college savings plans as a framework, the purpose of the ABLE Act was to create a new kind of tax-preferenced account under the newly created IRC Section 529A.
Similar to their college savings brethren, the new 529A (or “529 ABLE” or “Qualified ABLE program”) accounts will be funded with after-tax dollars, but all growth inside of the account is tax-deferred, and distributions for “qualified expenses” will be tax-free. In the context of 529 ABLE accounts, such eligible expenses will include education, housing, transportation, employment support/training, assistive technology and personal support services, health and wellness, financial management and administrative services, legal fees, expenses for oversight and monitoring, and funeral and burial expenses. If a distribution is not eligible for tax-free treatment, it is deemed to be a pro-rata distribution of principal and gains, and any gains are subject to both ordinary income treatment and a 10% early withdrawal penalty.
In order to create a Section 529A plan, the beneficiary must be someone who is receiving Social Security disability (or aid from a state program funded by Social Security) for blindness or a disability that began before the age of 26. Alternatively, an individual can be an eligible beneficiary of a 529A plan if a physician will certify that the individual is blind or disabled, due to an impairment that began before the age of 26, and that is expected to result in death or has lasted (or will last) for at least 12 months.
Contributions to 529A plans must be made in cash (no in-kind contributions of securities). However, unlike 529 college savings plans, total contributions in a single year to a 529 ABLE account (from any/all sources and contributors combined) are limited to the annual gift tax exclusion amount (currently $14,000 in 2015). In addition, similar to 529 college savings plans, the maximum contribution limit is reduced to $0 (i.e., no more contributions can be made) once the account balance exceeds the state-based maximum funding amount (though the account balance inside the 529A plan can continue to grow beyond that point). Excess contributions above the applicable annual limit are subject to a 6% excess contributions penalty if not corrected in a timely manner. Because by definition contributions will be within the annual gift tax exclusion limits, no gift taxes will be due for funding a 529A plan (although the contribution will count towards the contributor’s total annual exclusion amount available for the year).
Beneficiaries establishing a 529 ABLE account can only have one 529A plan, and unlike 529 college savings plans must use the 529A plan offered by their state (though if the state does not make a 529A plan available, the state can contract to make another state’s 529A plan available to its residents instead). Beneficiaries who relocate to a different state can complete a tax-free (60-day) rollover once per year from the old state’s plan to the new one. In addition, the beneficiary of a 529A plan can be changed to another member of the family, although the new family member must also be an eligible disabled beneficiary.
As with all Section 529 plans, the 529 ABLE accounts will be limited to whatever investment choices are made available in the plan itself, and investment allocations can only be changed twice per year (up from once per year, as a part of the tax extenders legislation).
Impact Of 529A ABLE Plans On Medicaid, SSI, And Other Federal Or State Aid
A key benefit of Section 529 ABLE accounts is that, unlike other assets of a disabled beneficiary, the value of a 529A plan is generally not considered when determining eligibility for means-tested Federal and state aid.
However, there are some limitations on excluding the value of 529 ABLE accounts for disabled beneficiaries receiving Supplemental Security Income (SSI) from Social Security (above and beyond Social Security Disability Income [SSDI] benefits). In the case of SSI, benefits will be suspended once the value of a 529A plan for the beneficiary exceeds $102,000 (as assets above $100,000 are treated as a resource for SSI purposes, and resources in excess of $2,000 will disqualify the beneficiary from SSI). SSI benefits can be restored if/when the account balance falls back below $102,000. In addition, to the extent that an otherwise-qualified distribution from a 529A plan is used specifically for housing expenses, the distribution is treated as countable income for SSI (potentially disqualifying the beneficiary from some or all SSI benefits).
While 529A plans don’t have any further impact on Federal or state aid, including Medicaid eligibility, it is notable that under the ABLE Act and the new IRC Section 529A(f), any remaining funds in a 529A account at the death of the beneficiary must be used to repay the state for any Medicaid assistance received by the beneficiary after the account was created. In this context, the state is treated as a creditor of the 529 ABLE account, and may file a claim to recover to the extent of prior Medicaid assistance expended on behalf of the beneficiary. If any funds remain after the state is repaid, the remainder goes to the post-death designed beneficiary of the 529A account (where gains will be taxable as ordinary income but the 10% penalty will be waived); if the state’s Medicaid payback claims are greater than the entire account balance, the state has no further recourse against any other of the disabled beneficiary’s assets (as the state is a creditor of the 529 ABLE account itself, not the disabled beneficiary).
Comparing 529 ABLE Accounts To Third-Party Supplemental Special Needs Trusts
Notably, in practice a 529 ABLE account is very similar to the so-called “(d)(4)(A)” special needs trust – a form of “self-settled” special needs trust (technically created by a third-party but using the disabled individual’s own assets) that can be used for the supplemental needs of a disabled beneficiary without currently disqualifying the beneficiary from Medicaid, and that is also subject to a state Medicaid payback provision after the death of the disabled beneficiary.
On the other hand, special needs trusts created and funded by a third party – e.g., the disabled beneficiary’s parents or other family members – are generally not subject to a Medicaid payback provision, and instead assets can be used for supplemental needs of the beneficiary, avoid disqualifying the beneficiary from aid, and any remaining assets can flow fully to the surviving family members or other beneficiaries after death of the disabled beneficiary without any requirement to repay the state for aid given.
In this context, having parents or other family members fund a 529A plan on behalf of a disabled beneficiary is distinctly less favorable than using a third-party supplemental special needs trust, due to the presence of the Medicaid payback provision. In addition, a third-party special needs trust is not limited in annual contributions like a 529A plan is (though contributors must still consider the potential gift tax ramifications), does not have maximum account limits that disqualify further contributions like the 529 ABLE accounts, is not subject to unfavorable tax treatment if used for other purposes, does not begin to disqualify a beneficiary from SSI once the account balance reaches $102,000, and does not have an age-of-disability-onset requirement nor a requirement that the beneficiary actually qualify for disability under Social Security or a doctor’s certification (in point of fact, anyone “could” establish a third-party supplemental needs trust on behalf of a beneficiary, disabled or not).
Nonetheless, the reality is that there are some benefits to establishing a 529 ABLE account – even when funded from family members whose contributions will ultimately become subject to the Medicaid payback provision. The first is simply the favorable income tax treatment itself; 529A plans enjoy tax-free growth (at least when used for qualified expenses), while third-party special needs trusts are subject to income taxation (and at compressed trust tax rates with a top 39.6% rate beginning at $12,300 of income in 2015, ameliorated only slightly by the higher personal exemption available for a qualified disability trust). Second, there is a drafting cost to an attorney to establish a (properly written) special needs trust, and ongoing costs to file annual tax returns for the trust, not to mention the work the trustee must undergo (and/or be paid for) to administer and oversee the trust; these costs should be largely eliminated with the simplicity of using a Section 529A plan (which at the most will likely have just a small annual maintenance fee). And in situations where the anticipated dollar amounts into the trust won’t exceed $102,000 anyway, and/or where the funds are expected to be used during the life of the beneficiary (so there won’t be anything left at death anyway), the issues of potential SSI disqualification and Medicaid payback may be a moot point.
Of course, for families who wish to fund larger dollar amounts on behalf of a disabled beneficiary (either now in excess of the annual contribution limit, and/or over time in excess of the maximum account limit), the 529A plan simply will not be practical. Similarly, families that expect there will be funds remaining in the account will not likely want to use a 529A plan if the beneficiary is receiving benefits from Medicaid due to the state payback provision. However, families creating a third-party supplemental special needs trust might wish to also create a 529A plan, funded over several years up near the $100,000 threshold (or if the beneficiary isn’t receiving SSI anyway, even higher), with the expectation of enjoying years of tax-free growth and then using the 529 ABLE account assets first, spending them down so there isn’t anything left for Medicaid repayment and leaving the remainder of the separate special needs trust available for further needs (and able to be bequested to surviving family members if not used). In fact, given the anticipated low cost and ease of use of 529A plans, there is arguably little reason why a family creating a third-party special needs trust wouldn’t at least fund a few years’ worth of contributions for the 529 ABLE account, just to enjoy some tax-free growth to further support the disabled beneficiary with a least a portion of the funds.
Ultimately, the biggest caveat to Section 529A plans is simply that no states have yet actually created any Qualified ABLE Programs, as it will take some time for the Treasury and IRS to issue regulations and guidance, and states to decide whether to take action and separately create the new account type. While the process for states to establish 529A plans should be expedited by the fact that the accounts will use much of the existing Section 529 college savings plan framework, it will still take some time for accounts to become available. In many cases, smaller (i.e., less populous) states may decide it’s not worth the administrative cost to offer their own plans given the limited number of potential beneficiaries to use them, so it seems likely that a subset of larger states will create plans that are later contracted out to other states… which means it may be a year or few ultimately families can open 529 ABLE accounts for disabled beneficiaries in most states across the nation.
Nonetheless, with the ABLE Act now signed into law, it’s only a matter of time before states begin to roll out their Section 529A plans for disabled residents of the state, and families planning for special needs children must consider whether to use an ABLE account or a special needs trust… or both. While there are some significant caveats to the 529A plans – in terms of both the dollar amounts that can go in, and the looming Medicaid payback provision at the end – they will likely be appealing for those that don’t want to go through the cost and hassle of drafting and managing a special needs trust (especially for account balances under $100,000) and may also be appealing as a supplement to a special needs trust, allowing a portion of the funds to grow tax-free and then be used for the disabled beneficiary first, while the rest of the money is set aside for larger future needs or contingencies, and can remain available to the rest of the family if not used at all.
