What is the difference between a third-party special needs trust and a self-settled trust? The distinction can be way more confusing than it ought to be. The trusts are similar in a number of ways, but there are important differences.
A few months ago, we explained self-settled special needs trusts in this space. Those are the kind of trust one might set up for a beneficiary who just settled a lawsuit, or received an (unrestricted) inheritance.
Third-party special needs trusts are different, as we explained in an earlier podcast episode. The funds come from a completely separate person (the “third party”, if you will), like a parent or grandparent. The rules governing the two kinds of trusts are different in significant ways.
Is my trust self-settled, or third-party?
The basic difference between the two types of special needs trust: where did the money come from? Was it really the beneficiary’s money (as in a personal injury lawsuit settlement, or an unrestricted inheritance)? Or did it go directly from someone else into the trust (as in a will leaving money to the special needs trust)? As one of our favorite colleagues explained some time ago, there are a number of distinctions to consider. But the key one is: whose money was it?
Some lawyers insist on calling third-party trusts “supplemental benefits trusts.” Confusingly, other lawyers insist on using that term for self-settled trusts. Others use “supplemental needs” for one, the other, or both types of trusts. The bottom line: don’t look at the names as a clear distinguishing factor.
Often the name of a trust will include clues about the type of trust. Just as often, however, nothing about the name of the trust will indicate whether it is a self-settled or third-party special needs trust. In fact, the name of the trust may not even include the term “special needs” at all. We often avoid including the phrase in a trust’s name to help avoid labeling — or identifying — the beneficiary or the disability.
Which would I prefer to have?
The answer here is easy: the third-party special needs trust can be far more useful and flexible than its self-settled cousin. There are a number of limitations imposed on self-settled trusts, including the requirement of a payback provision for Medicaid payment received by the beneficiary. Arizona, like some other states, imposes additional restrictions on how a self-settled trust can be used. Those restrictions — and the payback requirement — do not apply to third-party trusts.
Unfortunately, it’s not usually possible to simply decide which kind of trust you want to have. If the money already belongs to the beneficiary, the trust will be self-settled. But note: that choice IS available to the family member who wants to leave something to the beneficiary. It’s critical that the generous family member establish a third-party special needs trust to receive any inheritance. It can’t be done after the gift, or after the death of the donor.
Won’t the trust affect the beneficiary’s SSI, Medicaid, etc.?
With proper drafting and administration, there will be no reduction in or loss of public benefits. Good legal and accounting advice is essential, but it is easy to avoid loss of benefits.
But wait: sometimes you might prefer to reduce (or even eliminate) public benefits if the beneficiary’s life would be better. A well-advised trustee can figure out when to use the trust to improve the beneficiary’s quality of life. That kind of flexibility may not be available with a self-settled trust.
Because there is no payback requirement, the third-party trust can also go to other family members — or to charity — on the death of the primary beneficiary. Once again: if you have a family member with a disability, it is critical that you get good legal advice about the use of a third-party special needs trust.
Isn’t a third-party trust expensive? Aren’t there alternatives?
While planning how to leave money to your family member with a disability, you might run into the idea of ABLE Act accounts, or (if they are still young) UTMA accounts. Both have their places, and each can be useful in ways that a third-party special needs trust is not. But neither is a substitute for good special needs planning.
Talk with your lawyer. The expense will likely surprise you — not because it will cost a lot, but because it will be very reasonable. Don’t go shopping for the cheapest alternative you can find, online or otherwise. Actually engage in a conversation with your lawyer about her familiarity with the issue, her experience and her understanding of your wishes. Insist on your estate plan addressing your needs and wishes. And don’t be surprised if you get advice to use ABLE Act accounts (particularly) or UTMA accounts (less often) as part of the plan.