An irrevocable Medicaid trust may be used to help protect assets from liquidation when the need for an extended nursing home stay arises. When this strategy works, a loved one’s admission to a long-term care facility doesn’t require a substantial spend-down of investments, meaning wealth can be preserved and transferred to the next generation. But no irrevocable arrangement should be entered into lightly, especially if there are viable alternative protection strategies available.
How the Strategy Works
The idea behind an irrevocable Medicaid trust is to simulate a gift through the use of a trust. When establishing this kind of trust, the donor typically names their children as trustees and beneficiaries and then funds the trust with certain assets (e.g., their residence and investments). As long as contributions are made to the trust more than five years before the donor applies for Medicaid long-term care benefits, the state Medicaid office will not penalize the donor for transferring assets to the trust, and the existence of the assets will not affect Medicaid eligibility.
What to Consider Before Establishing a Medicaid Trust
While an irrevocable trust can be a powerful asset protection tool, there are a lot of client-specific priorities and circumstances to balance when assessing whether it’s a smart approach. Be sure to review the following considerations with your clients before they make a decision.
Passing control to a trustee. The family dynamic between the intended trust parties is the first thing to consider. Before entering into an irrevocable arrangement, your client should be comfortable with how the assets will be used prior to their death. Neither the client nor the client’s spouse may be a beneficiary of the trust principal, which means the trustee may be able to use the trust assets for a named beneficiary during the donor’s lifetime against the donor’s wishes. For that reason, it is often advisable that clients avoid entering into an irrevocable arrangement unless they’re confident that the named trustee and/or beneficiaries share their intentions for the trust assets.
To alleviate some of these concerns, trusts usually can be drafted to preserve the donor’s ability to occupy real property held in the trust for their lifetime and to allow the donor to change the beneficiaries who will inherit the trust property. In some states, clients can serve as their own trustee and be entitled to receive income from the trust. These clients should consider, however, whether being subject to the scrutiny associated with serving as trustee and having a right to income is in their best interest, as any income received would be forwarded to their nursing home should long-term care become necessary.
Tax implications. I think of the phrase “my client has a trust; can he do X?” the same way as “my client has a car; can he make it up Mount Washington?” Just as I would need to know the make, model, and condition of the car before deciding its capacity, I would need to know the specific terms of the trust to understand the legal and tax implications of funding it.
Financial planners are not tax advisors, however, so it’s important to discuss tax considerations with the attorney drafting the trust to ensure that a comprehensive analysis has taken place. Here are a few tax-related notes to keep in mind:
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Clients often seek to protect investments and real property during Medicaid planning. Will the trust beneficiaries be subject to unnecessary capital gains tax obligations because contributions to the trust are deemed taxable gifts? If the irrevocable Medicaid trust is drafted correctly, contributions would not be countable for Medicaid purposes but would still be included in the donor’s gross estate. This would ensure that the trust assets receive a step-up in basis at the donor’s death, which can significantly reduce any capital gains tax owed.
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Will the trust income be taxed at the donor’s rate or the trust’s rate? If drafted as a grantor trust, the trust’s income can be included on the donor’s tax return—without necessarily requiring income to be distributed to the donor.
Potential effects on care. It’s important to realize that while the irrevocable Medicaid trust strategy is designed to preserve wealth, it anticipates that clients will make use of the government-sponsored Medicaid program to pay for a portion of their care. This could have an effect on the choice (and sometimes quality) of care the client will receive. While there are certain laws against patient discrimination based on source of payment, it is a common fear (rational or not) that facilities have different accommodations for patients who pay with private funds and for those who use Medicaid.
How to Overcome Qualified Account Obstacles
Clients often hit a stumbling block with irrevocable trusts when their portfolio is heavily weighted with retirement accounts. Qualified plan and/or IRA participants cannot transfer ownership of their accounts to a trust, making liquidation of some or all of the account the only way to fund the trust. In this case, there are a number of questions to discuss with clients:
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Does the client’s state consider retirement accounts countable assets for Medicaid? A number of states consider required minimum distributions as income but exempt the account. Other states count the institutionalized individual’s qualified account as an asset but exempt the spouse’s account when assessing Medicaid eligibility. Still other states count the entire qualified account as an asset in a Medicaid eligibility assessment, regardless of payout status.
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If retirement assets are not exempt, is there a pressing medical condition that could justify liquidation? If there is, the likelihood that the individual will need long-term care within the next five years should be considered to determine whether, from a tax perspective, a strategic multiyear withdrawal may be more appropriate. Clients should also consider whether the potential beneficiaries would receive the inherited assets during high-income-earning years; this would further justify a withdrawal for protection purposes, as the realization of income by an elderly individual, rather than younger beneficiaries, might result in less of an income tax hit.
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Given the five-year “waiting period” that exists with an irrevocable Medicaid trust, is there another strategy to protect the qualified accounts when the need arises? If the individual in need of long-term care has a healthy spouse, then there may be complex strategies available to spend down or transfer assets in excess of the available exemptions when the nursing home need arises. For example, clients may be able to make a transfer to their healthy spouse through the use of a single premium immediate annuity.
The medical treatment aspect of a nursing home stay can be tax deductible. So if assets are needed to cover long-term care costs, then retirement accounts are typically the preferred source of payment. This is because as the assets are withdrawn, generating a tax liability, the medical costs represent an offsetting deduction.
Informing Your Clients’ Long-Term Plan
Irrevocable Medicaid trusts are certainly not ideal for all clients. But by maintaining an understanding of their value and when their use is (or is not) appropriate, you can help ensure that your clients have the right plan in place to achieve their goals and preserve wealth for the next generation.
Commonwealth Financial Network® does not provide legal or tax advice. You should consult a legal or tax professional regarding your individual situation.
Editor’s Note: This post was originally published in July 2018, but we’ve updated it to bring you more relevant and timely information.
