Your Loved One’s Trust Is Set Up. Now Comes the Part Families Can Miss. - Part 1

You did the hard work. You worked with an attorney, set up a special needs trust, and took a big step toward protecting your loved one’s future. That matters enormously because not every family gets there.

But here’s something most families don’t hear until it’s too late: setting up the trust is only half the job. Funding it, and how the money inside it is invested, matters just as much.

PART 1: The Tax Problems Special Needs Trusts Face

The IRS Treats Trusts Very Differently Than People

When you earn income personally, from a job, investments, or elsewhere, the IRS gives you a lot of room before hitting you with the highest tax rates. In 2026, a single person generally doesn’t reach the top federal tax rate of 37% until their taxable income exceeds $640,600. For a married couple, that threshold is $768,700.

A special needs trust gets almost none of that room. Under current tax rules, a trust may reach that same 37% rate when it has as little as $16,000 of taxable income in a year. That’s not a typo… $16,000. And this doesn’t even include the additional state income tax.

The reason this becomes a problem is that income generated by investments inside the trust, or distributions from retirement accounts, is often taxed at the trust level rather than passed through directly to the beneficiary. In many cases, the trustee has little choice in the matter. Special needs trust rules often restrict how and when money can be distributed, and distributing income directly to the beneficiary could jeopardize their eligibility for critical government benefits like Medicaid or Supplemental Security Income (SSI). So the income stays in the trust and gets taxed at those compressed trust rates even when everyone involved would prefer another option.

What this means in plain terms: if the investments inside the trust are generating a lot of taxable income each year, like interest payments, stock dividends, or profits from selling investments, a large portion of that money may go straight to the IRS instead of to your loved one. The trust can quietly lose value to taxes year after year, often without anyone realizing it’s happening.

The Retirement Account Problem (IRA / 401(k))

Many parents plan to leave their retirement savings, like IRAs or 401(k)s, to the special needs trust when they pass away. This is a common and understandable choice since these accounts often represent the bulk of a family’s savings. But it comes with a significant tax challenge.

When a trust inherits a retirement account, current federal law generally requires that the entire account be withdrawn and taxed within ten years. If the account is large, that can mean a significant tax bill hitting the trust over a relatively short period of time, all at those unfavorable compressed trust tax rates.

Even when an exception applies, the trust may still be required to take money out of the retirement account every year. Each of those withdrawals is generally treated as taxable income. If the total taxable income the trust receives in a year exceeds $16,000, the highest tax rate kicks in on everything above that threshold.

The Problem with High-Income Investments Inside the Trust

If the trust holds a regular investment account, sometimes called a brokerage or non-qualified account, the same compressed tax bracket problem applies. Some investments naturally pay out a lot of income every year from things like certain bonds or high-dividend stocks.

In a personal account, that income might not be a big deal. But inside a special needs trust, that same income can quickly trigger high taxes. The trust can lose a meaningful portion of its growth to taxes every single year, quietly eroding the very funds meant to care for your loved one.

The good news? There are strategies that can help.

Next week, we’ll walk through the specific approaches families can use to fund and invest a special needs trust more tax-efficiently, from Roth conversions to life insurance to smarter investment strategies inside the trust itself.

Can’t wait until next week? Reach out now and we can walk through your loved one’s specific situation together.