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Special-needs trust is key part of some estate plans

Shortly after their two children were born, Ed Underwood and his wife, Mary Valentino, decided they should do some estate planning. In 1999 the couple worked with an attorney to draft wills and other documents that are typically part of an estate plan.

But not long after that, their lives changed dramatically. At the age of 3, their first child suffered the onset of severe epilepsy and developmental regression. It eventually became clear to the couple that their son would have lifelong special needs and that they needed to rethink their estate plan.

Disabled child
Katja Kircher | Getty Images

In 2006 they revised their estate plan and, in the process, created a special-needs trust to benefit their disabled son. Special-needs trusts, also called supplemental-needs trusts, can be a critical estate-planning tool for parents of children who are likely to need special care and financial support throughout their lives.

The trusts address a difficult dilemma for many families: how to pass on assets to a disabled child without jeopardizing his or her eligibility for means-tested government benefits, such as Medicaid, Medicare and Supplemental Security Income.

Disabled individuals with as little as $2,000 in available assets may not be eligible for public benefits. Assets held in special-needs trusts, which are managed by assigned trustees, don't count toward eligibility calculations for public benefits, according to experts.

Funds in the trusts can be used to pay for items that aren't covered under government programs, such as dental work, eyeglasses, haircuts and caregiver charges. The money can also be used to pay for enrichment, such as trips to visit family members and specialized educational programs.

"Government benefits provide a safety net, but often parents of special-needs children want to provide a higher quality of life, and that's where special-needs trusts come into play," said Nancy Nauheimer, a certified financial planner and senior financial consultant at Northern Trust Corp.

Like any complex legal document, a special-needs trust should be drafted by an attorney, ideally an experienced estate lawyer who understands special-needs planning and government benefit programs for the disabled, experts say. Some families work with both attorneys and financial advisors who focus on special-needs planning.

Poor draftsmanship of special-needs trusts can have serious consequences for disabled beneficiaries, explained Henry Klosowski, a partner and chairman of the trusts and estates group of Moritt Hock & Hamroff.

"What a special-needs trust can never do is have language in it that allows money to be given directly to the disabled individual," said Klosowski. That language, he added, may cause beneficiaries to become ineligible for Medicaid, a federal-state program that helps pay for health care for the disabled and other groups.

Timing is another important consideration for parents of children who might benefit from a special-needs trust. Some parents opt to wait until their kids are in the age range of 18 to 21 to establish special-needs trusts, according to Nauheimer of Northern Trust.

That's because disabled individuals tend to rely more heavily on public benefits as they "age out" of public school systems or other community-based programs. At that point, parents may have a better sense of their kids' long-term abilities, prospects and needs.

"The trusts are often created when a child reaches the age of maturity and parents have a better sense of whether the child will ever achieve financial independence, have the mental capacity to make financial decisions, be able to live independently and what supports will be available to the child," Nauheimer said.

Some parents, said Klosowski of Moritt Hock & Hamroff, take a wait-and-see approach. "You can put the trust inside a will and have trust language that says that if the disabled child is receiving Medicaid at the time of the parent's death, then the trust is a supplemental-needs trust," he said. "Otherwise, it is a [basic] support trust."

"Special-needs trusts are not the exclusive domain of wealthy individuals, although there is that perception." -Nancy Nauheimer, senior financial consultant at Northern Trust

Choosing a trustee (or co-trustees) to oversee a special-needs trust is another big decision for parents. Trustees, experts say, must not only act in the best interest of disabled beneficiaries but should be sophisticated enough to follow trust-administration rules and guidelines.

On top of that, parents should try to pick a trustee who knows the disabled child and is willing to comply with their wishes for that child, which are sometimes spelled out in a letter of intent that accompanies a special-needs trust, experts say.

Very often, trustees are family members who will care for a disabled person after his or her guardian dies. In some cases, special-needs trusts are managed by corporate trustees.

"Find someone who is trustworthy, knows your child and will comply with your letter of intent," said Lili Vasileff, a certified financial planner and president of financial planning firm Divorce and Money Matters and parent of a special-needs child. Vasileff, who specializes in both divorce and special-needs planning, set up a special-needs trust for her disabled daughter and named her son and a family friend as co-trustees.

Of course, caring for a disabled child can be a big financial drain, and families that are stretched thin may wonder whether they can even afford to plan, said Nauheimer of Northern Trust.

"Special-needs trusts are not the exclusive domain of wealthy individuals, although there is that perception," she explained. "I'd like to dispel that notion, because there are ways to structure and fund a trust so that there are sufficient resources."

Life insurance policies can be used to fund the trusts, although some advisors urge caution when it comes to relying on "second-to-die" policies as a funding mechanism. Such policies typically cover two people, usually a married couple, and provide benefits to their heirs only after both die.

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"These policies can be relatively inexpensive, but the problem is that when the first spouse dies, the surviving spouse may not have enough money to pay for care of the disabled child" and other expenses, said John Nadworny, a CFP and author of "The Special Needs Planning Guide: How to Prepare for Every Stage of Your Child's Life."

It also behooves parents who have set up a special-needs trust for their disabled child to spread the word to grandparents and other relatives who might want to pass on assets to that child, experts say.

"Make sure family members are aware of the trust's existence and that their own financial plans are coordinated with the trust," said Northern Trust's Nauheimer. "You don't want little Johnny to receive assets in his name that would make him ineligible for government benefits."

— By Anna Robaton, special to CNBC.com