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I was working with a financial advisor who had a client whose adult son with special needs inherited a house worth $200,000 from his grandfather. This young man was receiving Medicaid for his healthcare and SSI for his living expenses.
Inheriting that house directly would have immediately disqualified him from both programs.
This is where establishing a first-party special needs trust can come into play. This strategy transfers the assets into the trust, and the trust can be used to improve the quality of his life.
Without the trust, he would have lost his Medicaid coverage and been forced to spend almost the entire $200,000 on his care before requalifying for benefits. The trust preserved his eligibility while dramatically improving his life.
However, I wish I had known the family earlier, as there would have been a better way to handle this from the start. We will examine this later.
Understanding the Two Types of Special Needs Trusts: First-Party and Third-Party Explained
For those of you who know me, I “Dad Joke” to the point of annoyance.
So when I started this conversation with the financial advisor's client about Special Needs Trusts, I said, “There are two types of trusts, the first party trusts, and third party trusts, and the shame is that I was never invited to either party.” They just blankly stared at me on the Zoom.
This is precisely why I do not quit my day job at Dunham.
Jokes aside, this “two-party” distinction is very important.
Let us take a closer look at what makes them different and why it matters so much.
What Happens If You Inherit Assets Without a Special Needs Trust?
When the son inherits that $200,000 house directly from his grandfather, here is what immediately happens and what is at stake.(1)
Immediate Disqualification from Benefits
The moment the house is transferred to the son's name, he now owns an asset worth $200,000. Government benefit programs have strict asset limits of typically $2,000 in most states. He is now $198,000 over the limit. His Medicaid coverage stops. His Supplemental Security Income stops. These benefits do not pause or reduce gradually. They terminate.
You Must Quickly Report the Inheritance or Other Assets
It is important to note that when the son receives the house as part of his grandfather’s inheritance, the clock starts ticking immediately. Often, families are unaware of deadlines that can result in thousands of dollars in costs.
If the son receives Supplemental Security Income, the family has exactly 10 days to report this inheritance, or any asset, to the Social Security Administration (SSA). Ten days from the moment the check clears or the property deed transfers.
If the family misses that deadline, SSA will demand repayment of every dollar of benefits paid after your loved one exceeded the $2,000 asset limit, even if that money already went to rent, food, or medical care. They will also impose financial penalties on top of the overpayment and can suspend benefits entirely. In extreme cases, they may treat the failure to report as a form of fraud.
Medicaid Recipients Have State-Specific Requirements(2)
Since the son receives Medicaid, the family faces a separate reporting requirement to their specific state Medicaid agency. Reporting timelines vary by state, typically ranging from 10 to 30 days. However, the consequences of missing the deadline mirror those of the SSA penalties, which can include overpayment recovery, potential penalties, and possible fraud allegations.
The Exceution Made for Social Security Disability Insurance
Social Security Disability Insurance (SSDI) works differently. SSDI is an earned benefit based on work history, not a welfare program. It has no asset limits. Someone receiving only SSDI can inherit millions and keep their benefits without reporting anything. However, many people receive both SSDI and SSI, which means the reporting requirements still apply.
Loss of Healthcare Coverage(3)
Medicaid is not just health insurance. For many people with disabilities, Medicaid pays for services that private insurance will not cover or severely caps. When the son receives the inheritance, the type of covered expenses he may lose includes:
- Ongoing therapies (physical, occupational, speech)
- Specialized medical equipment
- In-home care services
- Supported living programs
- Day programs and vocational services
- Medications
Without Medicaid, the family must pay out of pocket for all of this.
Loss of Income
The monthly SSI income will also stop when the son receives the inheritance. This is the money that pays for daily living expenses. When SSI stops, that income disappears immediately.
What Is a First-Party Special Needs Trust and How It Works
A first-party special needs trust gets funded with assets that belong to the person with disabilities, in this case, the son, when he inherits his grandfather’s house. However, this could also include money from personal injury settlements, other inheritances left directly to him, back pay from disability benefits, or any other asset for which he had a legal right to receive it.
I often see this with settlements. If the special needs child wins a lawsuit and receives $500,000, that money is legally theirs. However, if they take it directly, they risk losing their government benefits. Instead, they should consider placing that money in a first-party trust, where it can be used to enhance their quality of life without disqualifying them from the benefits they need.
Payback Language
Federal and state law require these trusts to include provisions that give the state first priority on any remaining assets when the beneficiary dies or the trust is terminated prematurely. The state gets reimbursed for every dollar of Medicaid benefits it paid on behalf of your loved one. Only after the state has collected can any remaining funds be distributed to family members.
Why Families Use Third-Party Special Needs Trusts in Estate Planning
Remember how I said I wish I had known the family earlier, before the grandfather’s demise? This is because, with proper planning, we could have avoided all of these complications by establishing a third-party Special Needs Trust.
A third-party special needs trust is funded with money from someone other than the individual with special needs, typically from parents, grandparents, or other family members. The key distinction is that the person with disabilities never owned these assets and never had a legal right to them.
You are giving your money to a trust for the special needs child’s benefit.
In our case, the grandfather would have left the house to a third-party trust during his estate planning, rather than leaving it to his special-needs grandson.
No Payback Provisions and No Disruption of Government Benefits
One of the beautiful aspects of a third-party special needs trustee is that there are no payback requirements.
Zero.
When the child passes away, the remaining assets in the trust are distributed to the child's siblings, other family members, charities, or any other designated beneficiary. The state does not get a penny back because it never had a claim to the money in the first place.
Third-party trusts are a wonderful planning tool. You control where the money comes from, how it gets used during your child's lifetime, and where it goes afterward.
What Expenses Can a Special Needs Trust Pay For?(4)
Both first-party and third-party special needs trusts can pay for a wide range of expenses that supplement, but do not replace, the government benefits, such as:
- Medical and dental care not covered by Medicaid
- Therapy, rehabilitation, and specialized training programs
- Educational programs and tutoring
- Transportation costs and vehicle modifications
- Assistive technology and adaptive equipment
- Home modifications for accessibility
- Personal care attendants beyond what Medicaid provides
- Computers, tablets, phones, and electronics
- Recreation, entertainment, and hobbies
- Vacations and travel
- Clothing and personal items
- Professional services like care managers or legal counsel
Remember, third-party special needs trusts can pay for these same expenses, but without the Medicaid payback requirement that first-party trusts carry. This provides families with more flexibility and ensures that remaining funds are allocated to loved ones rather than the state.
What Special Needs Trusts Cannot Pay For (4)
Understanding what a first or third-party special needs trust cannot pay for is equally important.
- Direct cash payments to the beneficiary (triggers benefit reduction)
- Basic food and shelter costs paid directly to the beneficiary (reduces SSI by up to one-third)
- Expenses already covered by government programs
- Gifts to other people
- Charitable donations made by the beneficiary
- Anything illegal
The food and shelter restriction trips up many trustees. If the trust pays rent directly to a landlord or mortgage company, it can result in reduced SSI payments. Proper trust administration, such as that provided by Dunham Trust, can work around these limitations because we are familiar with these rules.
How Trustees Should Make Payments
Trustees must never give cash directly to the beneficiary. Instead, they pay vendors, landlords, medical providers, schools, and service providers directly. This preserves benefit eligibility while ensuring the beneficiary receives what they need.
Trustees must also keep detailed records of every distribution, document how each expense benefits the beneficiary, and understand how different payments might affect SSI or Medicaid eligibility. One incorrect payment can result in benefit reductions or termination.
Avoid This Common IRA Mistake in Special Needs Planning
Here is a mistake I often see. Parents and family members name a special needs child as a beneficiary of their IRA or 401(k). This dumps a massive taxable asset directly to someone who will immediately lose government benefits. The entire IRA is counted as an available resource, and the required minimum distributions are considered income.
It could be a disaster.
The solution is to name a properly drafted third-party special needs trust as the IRA beneficiary instead. This protects benefits while allowing the funds to be used for the child's care.
At Dunham Trust, we have an affordable solution specifically designed for these situations. We help families structure these trusts correctly so their retirement accounts enhance their child's life instead of destroying their benefit eligibility.
Key Takeaways on First- and Third-Party Special Needs Trusts
Special needs planning is complex, but the consequences of getting it wrong can be devastating. Whether you are dealing with a settlement, inheritance, or your client’s estate planning, understanding the difference between first-party and third-party trusts can mean the difference between a secure future and financial catastrophe for your client’s loved one.
And while, like me, you may never be invited to the first or third party, helping families with these trusts and protecting their loved ones is the kind of work we would all like to do every single day in our careers.
Sources:
- How will Inheritance Affect Your Social Security Benefits?, by Turley, Redmond, & Rosasco, LLP, n/d, https://www.nydisabilitylaw.com/news-resources/how-will-inheritance-affect-your-social-security-disability-benefits/
- Will receiving an inheritance disqualify a Mediaid long term care beneficiary, by American Council on Aging, January 20, 2025,
https://www.medicaidplanningassistance.org/inheritance/ - Gov, by Mediaid.gov, n/d, https://www.medicaid.gov
- Special Needs Trusts Spending Rules, by LegalShield, May 29, 2025, https://www.legalshield.com/blog/special-needs-trust-spending-rules
Disclosures:
This communication is general in nature and provided for educational and informational purposes only. It should not be considered or relied upon as legal, tax or investment advice or an investment recommendation, or as a substitute for legal or tax counsel. Any investment products or services named herein are for illustrative purposes only and should not be considered an offer to buy or sell, or an investment recommendation for, any specific security, strategy or investment product or service. Always consult a qualified professional or your own independent financial professional for personalized advice or investment recommendations tailored to your specific goals, individual situation, and risk tolerance. All examples are hypothetical and are for illustrative purposes only.
Dunham & Associates Investment Counsel, Inc. is a Registered Investment Adviser and Broker/Dealer. Member FINRA / SIPC. Advisory services and securities offered through Dunham & Associates Investment Counsel, Inc. Trust services offered through Dunham Trust Company, an affiliated Nevada Trust Company.