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Life insuranceOnce the all-important question of “How much money should I plan to leave my child?” has been answered, the next step in special needs financial planning is to determine what assets will be used and when they will be passed on.

Typically, special needs trusts (SNTs) are not funded until the parents’ passing. This is because SNTs are complex and somewhat inflexible, and can create an administrative burden. Therefore, while the parents remain alive, it is often easier for them to provide for the child directly.  

Many peoples’ liquid assets are tied up in qualified retirement accounts such as IRAs or 401(k)s. These are typically very inefficient assets to leave to a trust. Because these accounts have never been taxed, they will be fully taxable as ordinary income once withdrawals begin. Trusts pay taxes at the maximum federal rate (39.6 percent) on undistributed income above approximately $12,000 (2016 figures). To put that in perspective, that’s the same tax rate as a household making over $466,000! Other taxes could also apply, such as state income taxes and the Medicare surtax (3.8 percent). These trust taxes could normally be avoided by distributing the income to the individual, but doing so could jeopardize public benefits for a child with special needs.

Roth IRAs and life insurance death benefits are generally much more efficient assets to leave to a special needs trust. Both are received income-tax free, and therefore avoid many of these tax issues. Special needs and financial planners, such as myself, often recommend life insurance as a funding mechanism for an SNT. This life insurance would almost always be permanent, as opposed to “term” insurance, because the financial need is permanent and term life insurance would likely expire before paying out.

The type of life insurance that I typically recommend is known as “second-to-die” or “survivorship” insurance, meaning that the policy’s death benefit doesn’t pay out until both parents/insureds have passed. This is generally universal life or whole life, which are both permanent in nature, but have some differences in how they operate. Whether to use a universal or whole life policy depends on the parents’ goals. 

If the goal is to simply leave as much money as possible for the child’s SNT, then universal life would be ideal, but if the parents want to create a significant cash value alongside the death benefit for possible use and more flexibility later, then whole life might be a better option.

Universal life

When a universal life policy is purchased, certain factors dictate how the policy performs and how long it lasts.  The two main factors are 1) How much premium the policy owner puts into the policy each year, and 2) the interest crediting rate. For example let’s say a 60-year-old couple takes out a $1 million universal life insurance policy. They plan on putting in $10,000 a year and, based on current interest rates (say 4 percent), the policy is projected to last until they are both age 100. If interest rates rise over time between now and then, and they continue to put in $10,000 per year, then the policy might actually last until age 105 or 110. Alternatively, as interest rates increase over time, they may have the option of putting less premium in and still have the policy last to age 100. 

Some people who expect interest rates to increase over time might fund a plan today based on this assumption, with the policy going to only age 90, in the hope that rising rates will push that out to age 95 or 100.  As an important history lesson which has ramifications today, many universal life policies sold in the past were not monitored over time and when they were purchased, interest rates were significantly higher than today. As interest rates steadily declined over the past decades people should have been increasing their premium contributions to make up for that fact, but in many cases they did not. To their surprise, many have received (or may soon receive) letters warning that their policy is going to lapse unless they pay some astronomical sum to continue it.

Any universal life policy, and especially older policies, should be monitored at least once a year by securing an “in-force illustration.”  Furthermore, the underlying formula to cover the cost of insurance technically is not guaranteed, which is why choosing a financially solid company with a strong track record is important. There are plenty of companies that have never had a premium increase on in-force policies, but the possibility does exist, so due diligence is advised. 

Whole life

Whole life insurance is in many ways simpler and carries with it more ironclad guarantees than does universal life, but it comes with its own pros and cons.  Unlike universal life, whole life, as its name implies, lasts the policy owners’ whole lives no matter when they pass, as long as premiums are paid.  A traditional whole life (second-to-die or regular first-to-die) policy typically builds a substantial cash value alongside the death benefit, and this cash value can be accessed during the policyholders’ lives. (Universal life also builds some cash value but it cannot usually be accessed without adversely affecting the policy’s death benefit projection.)

This cash inside of a whole life policy may be useful for meeting needs that may arise for the child with special needs, such as securing a residence for them.  Whatever cash value is taken out of the policy reduces the death benefit dollar-for-dollar up to the amount paid into the policy (the “cost basis”). If more is needed beyond that, taxes can be avoided by doing a “policy loan” that usually doesn’t have to be repaid, although any interest accrued is tacked onto the cash withdrawn to be subtracted from the death benefit when the insureds die. The premium on a whole life is guaranteed to never increase and there are customization options to have the policy “paid up” (no more premiums due) in the future.

In conclusion, having a legal and financial plan in place for a child with special needs at one’s passing is critical.  Because no one can predict what the future holds, it’s important that the foundation for that plan is set. Any one of us is potentially a health event away from life insurance rates to become unaffordable or even ruled out altogether. This is why it is recommended to lay the groundwork for this type of planning while the parents are in good health; in doing so, there will be more options and flexibility for the financial and estate plan down the road

Caleb Harty is the principal of Harty Financial & Insurance Services in Middleton, Massachusetts. 

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