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For families with a child or grandchild who has special needs, a properly drafted special needs trust (SNT) can be one of the most powerful planning tools available.
It can preserve eligibility for government benefits, provide supplemental support and create long-term financial stability.
But there’s a mistake I see far too often — one that can quietly undermine everything a family is trying to accomplish: Naming a special needs trust as the beneficiary of tax-deferred retirement accounts.
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At first glance, it seems logical. You want to protect your loved one, so you direct your IRA or 401(k) to their trust. Done, right?
Not quite.
In many cases, this creates a significant — and often unnecessary — tax burden that reduces what ultimately benefits your loved one.
Let’s walk through why.
The problem: Tax-deferred accounts come with a bill
Accounts such as IRAs, 401(k)s, 403(b)s, SEP IRAs and deferred-compensation plans all share one thing in common: They’ve never been taxed.
Every dollar in those accounts is subject to ordinary income tax when distributed. When you’re alive, you control when and how those taxes are paid. But after your death, that control shifts to your beneficiaries — and the rules change.
Under current law, most non-spouse beneficiaries must withdraw the full balance of an inherited retirement account within 10 years. That means the IRS is effectively saying: “We’ve waited long enough. Pay up.”
Now imagine that the beneficiary is not an individual, but a trust.
When a trust becomes the beneficiary
When a special needs trust is named as the beneficiary of a retirement account, things get more complicated.
Trusts reach the highest federal income tax bracket — 37% — at extremely low levels of income (slightly more than $16,000 in many cases). That means that if retirement distributions are retained inside the trust, they can be taxed at very high rates very quickly.
Even if distributions are passed through to the beneficiary, the timing and structure of those distributions might still create inefficiencies.
The purpose of a special needs trust is not just to hold money; it’s intended to stretch and protect it over time.
Large, accelerated taxable distributions can work directly against that goal.
The real risk: Losing a chunk of the legacy
Let’s look at a hypothetical example.
A parent passes away with a $1 million IRA and names their child’s special needs trust as the beneficiary.
Over the required 10-year period, that money must be distributed — and taxed.
Depending on how those distributions are handled, it’s entirely possible that:
- Hundreds of thousands of dollars go to taxes
- The trust is forced into high tax brackets early
- The long-term growth potential is significantly reduced
In other words, a portion of what you intended for your loved one ends up going somewhere else.
Why this happens so often
This mistake is rarely intentional.
It usually happens because two separate planning tracks aren’t coordinated:
- Estate planning (attorney). Create a special needs trust to protect the beneficiary
- Retirement planning (adviser or custodian). Assign beneficiaries to accounts
Both are done correctly — individually.
But without coordination, the result can be suboptimal.
A better way to think about it
Not all assets are created equal.
When you’re planning for a special needs beneficiary, it’s critical to understand that:
- Tax-deferred accounts (IRAs, 401(k)s) carry a future tax liability
- After-tax assets (brokerage accounts) might receive a step-up in basis
- Roth accounts are potentially tax-free to beneficiaries
From a planning standpoint, you want to be intentional about which assets go where.
Smarter strategies to consider
Every situation is different, but here are several strategies worth exploring:
1. Use tax-efficient assets to fund the trust.
Instead of naming the SNT as the beneficiary of a traditional IRA, consider funding the trust with:
- After-tax investment accounts
- Life insurance proceeds
- Roth IRA assets (in some cases)
These assets can often pass to the trust with less tax friction.
2. Leave tax-deferred accounts to other beneficiaries.
If you have multiple heirs, you might choose to:
- Leave IRAs or 401(k)s to individuals in lower tax brackets
- Use other assets to equalize inheritances
This can help improve overall tax efficiency across the family.
3. Consider Roth conversions during your lifetime.
Strategic Roth conversions can:
- Help reduce the future tax burden on inherited accounts
- Create more flexibility for beneficiaries
- Potentially allow tax-free distributions to the trust
You’ll pay taxes now — but you might be doing so at lower rates than your beneficiaries would face later.
4. Coordinate your estate plan and beneficiary designations.
This is where many plans fall apart. Your attorney, financial adviser and tax professional should all be working from the same playbook.
If your special needs trust is central to your plan, your retirement account strategy should reflect that.
The goal: Protection without unintended consequences
A special needs trust is designed to provide stability, protection and dignity for someone you care deeply about.
But if it’s funded inefficiently, it can also introduce:
- Higher taxes
- Faster asset depletion
- Less long-term flexibility
That doesn’t mean you shouldn’t use a trust. It means you should use one intentionally.
A simple question to ask: If you already have a special needs trust — or are planning to create one — ask, “Which assets are best suited to fund this trust, and which assets are not?”
That single question can help you avoid a costly mistake.
Final thoughts
Planning for a loved one with special needs is one of the most important — and emotional — financial decisions you’ll ever make.
You’re not just managing money.
You’re building a system of care that could last decades.
By aligning your tax strategy with your estate plan, you can help ensure that more of what you’ve built serves the person it was meant for.
That’s the outcome that matters most.
The appearances in Kiplinger were obtained through a PR program. The columnist received assistance from a public relations firm in preparing this piece for submission to Kiplinger.com. Kiplinger was not compensated in any way.
