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Date: June 1, 2011

In the world of Estate Planning, retirement plans are almost always part of the picture. While in general they can be great wealth building tools, in the specialized world of Special Needs Estate Planning, they can also present some very significant challenges, both for parents who want to leave retirement funds for the benefit of their children with disabilities, as well as for people with disabilities who work and need to qualify for Medicaid so that services and support can continue.

In this issue of the Special Needs Estate Planner, we share some challenges and possible solutions for individuals with disabilities who have accumulated money in these accounts and are seeking to establish eligibility for some of the main government benefit programs that provide support and services in the community. We’ll do our best to keep it short and sweet…

What exactly is a Retirement Plan?

This can be dense and complicated stuff, so let’s start with the basics just to be sure we’re all on the same page. While there are many different
types of retirement plans, we most often encounter the following types of plans:

  • Individual Retirement Accounts (IRAs). IRAs are retirement accounts that are owned and funded by individuals with income they have earned through employment.
  • 401(k) Plans. 401(k) plans are employer sponsored retirement plans that are funded by an employee’s salary deferral, and in some cases also by employer contributions. 401(k) Plans are typically offered by private and corporate employers.
  • 403(b) Plans. 403(b) plans function essentially the same way as 401(k) plans. They are retirement plans that are administered for the employees of educational institutions, hospitals and municipalities. Generally speaking, each of these plans is income tax deferred. This means that money you put into the plan is not taxable in the year of contribution, and it grows tax free. But when you withdraw funds from one of these plans, the amount withdrawn is considered taxable income. Thus the tax is deferred, and not avoided altogether.

There are also rules which govern the manner and timing of withdrawals from these plans. These rules are designed to encourage people to save for their retirement, and then use the money once they do retire. The two most important rules for our purposes are as follows:

  • Rule 1. Prior to reaching age 59 ½, a retirement plan owner who withdraws funds from his or her retirement plan will be subject to an excise tax (like a penalty) equivalent to 10% of the total distribution. This is in addition to the ordinary income tax that applies to the distribution. There are some exceptions to this rule, one in particular which will be discussed further on in this article. This rule is designed to encourage people to keep money in the plan until they retire.
  • Rule 2. Once an individual reaches the age of 70 ½, the individual must begin taking required minimum distributions from the retirement plan. The IRS has a special life expectancy table that is used to calculate one’s required minimum distributions. If the individual fails to take a minimum distribution after reaching age 70 ½, then there will be a 50% excise tax on the total amount of the required distribution. That excise tax is in addition to the ordinary income tax payable on the distribution. Ouch! This rule is designed to encourage people to use the money when they retire.

Enter the Need for Government Benefit Eligibility…

Disability comes in many different shapes and sizes. But whatever the nature and cause of the disability, people with disabilities often need help from one of the government benefit programs which provides support and services in the community. And as most of our readers are aware, government benefit programs like Medicaid and Supplemental Security Income (SSI) are means-tested. These programs count an applicant’s nickels. They count the amount and source of an applicant’s monthly income, and they also count the applicant’s resources (bank accounts, stocks, and other assets). So this raises a question: for those individuals with disabilities who have worked and accumulated money in a retirement plan, how will those plans be treated when it comes time to apply for benefits?

First and foremost, remember that 401(k), 403(b) and similar accounts will not impact financial eligibility while the applicant is still working for the employer which sponsors the plan. Because money in these plans cannot be withdrawn unless the participant leaves the employment, they are similarly considered unavailable in determining financial eligibility (for the SSI and Medicaid programs).

Many of our readers have family members who have recently been asked to qualify for Medicaid in order to continue to receive services that had, up to this point, been provided without charge. Often these individuals will be looking at the Medicaid Buy In program. Once eligible for the Buy In, they can continue to contribute to their retirement plans while they are still working without impacting eligibility for services (presuming other eligibility criteria are met as well). But remember – this only applies to plans sponsored by current employers. Once the individual leaves work, all bets are off.

What if the account is not a work related account, or the individual has left work and now has the right to withdraw or transfer funds from the account? The answer can be tricky. Under current SSI and Medicaid program rules, retirement plans can be counted either as a resource or as income, depending on whether the retirement plan is in payout status. Payout status means that the individual is making annual withdrawals from the account based his or her life expectancy.

If the retirement plan is in payout status, then for government benefit eligibility purposes, the underlying retirement plan value is disregarded and is not counted as a resource. Instead the annual payout is treated as income to the applicant. If the retirement plan is not in payout status, then for government benefit eligibility purposes, the value of the retirement plan is treated as an available resource to the applicant (i.e., the value of the retirement plan will count toward the applicable resource threshold).

In many (if not most) cases, the applicant is put in a better position by electing payout status, as it allows the majority of the account to remain intact and continue to grow tax free. But as we mentioned earlier, there are some potential income tax consequences to this approach.

Recall that if an individual is over 70 ½, a retirement plan should already be in payout status. So for our elderly clients applying for long term care benefits, they are already paying tax on their withdrawals.

For individuals younger than age 70 ½ and older than age 59 ½ who are not already in payout status, putting a retirement account in payout is typically a matter of filing the appropriate forms with the retirement plan administrator. The annual payout is considered taxable income, and so the individual needs to be aware of the potential for additional income tax liability.

The real challenge comes for individuals under age 59 ½ who have funds in a retirement plan which is not connected to their employment and now need to apply for SSI or (more commonly) Medicaid. These individuals are subject to an extra 10% penalty on those annual withdrawals, in addition to any income tax payable as a result of the withdrawal.

As mentioned earlier, the IRS does provide several exceptions to this 10% penalty rule. One of these exceptions is known as the disability exception. The disability exception can be difficult to apply for individuals who are still working yet need government benefits (like the Medicaid Buy In), as the IRS definition technically requires that the individual’s disability is such that it prevents any significant employment. How about that for a dilemma?

Finally, keep in mind that under current law and policy, the retirement plan owner (i.e., the person with the disability who is applying for benefits) is free to name his or her own beneficiary on the plan, meaning that whatever amount is left in the plan at the end of the benefit recipient’s lifetime will pass to that named beneficiary without having to be paid back to the State. A small benefit by all accounts, but a benefit nonetheless.

And then a closing comment. The rules governing the budgeting and treatment of retirement accounts are often applied inconsistently across different benefit programs, and can change very quickly. For individuals with limited assets outside of an employment related retirement account, simply understanding that the employment related account is exempt should be sufficient to secure SSI or Medicaid coverage (again, presuming all other criteria have been met). But for those who have assets in retirement plans that are not work related – an IRA or a retirement account from a prior employer, for example – we do recommend that the individual seek legal advice before applying for coverage. There may be some planning options that allow for at least a slice of cake, and eligibility for services too…

This newsletter is not intended as a substitute for legal counsel. While every precaution has been taken to make this newsletter accurate, we assume no responsibility for errors or omissions, or for damages resulting from the use of the information in this newsletter. If you would like to be removed from our distribution list, please email us or call us at (518) 881-1621