Special needs trusts protect government benefits while setting aside money for someone with a disability. But not all special needs trusts work the same way. The two main types are first-party and third-party trusts, and choosing the wrong one can create problems down the road. Understanding the difference matters because each type has distinct rules about funding, payback requirements, and who can create them.
What Makes Them Different
The primary difference comes down to whose money funds the trust. A first-party special needs trust holds assets that belong to the disabled person themselves. A third-party trust holds assets that belong to someone else, usually a parent or grandparent.
Specifics such as that affect everything about the trust, including how it operates. In particular, factors such as who can set up the trust, what happens to the remainder of the trust if the beneficiary dies, and the restrictions on distribution are all affected by this.
First-Party Special Needs Trusts
These trusts get funded with money or property that already belongs to the person with disabilities. Common sources include personal injury settlements, inheritance received directly, divorce settlements, or back payment of Social Security benefits.
Let’s say your adult son with special needs receives a $200,000 personal injury settlement. If that money goes directly to him, he’ll lose his Supplemental Security Income and Medicaid immediately because his assets exceed the eligibility limits. A first-party special needs trust solves this problem by holding those funds in a way that doesn’t count against benefit limits.
Key Requirements for First-Party Trusts
First-party trusts come with strict federal requirements under 42 U.S.C. § 1396p(d)(4)(A):
- The beneficiary must be under age 65 when the trust is established
- The beneficiary must meet Social Security’s definition of disabled
- The trust must be created by a parent, grandparent, legal guardian, or court
- The disabled person cannot create their own first-party trust
There’s another important requirement. When the beneficiary dies, any money left in the trust must first go to repay Medicaid for benefits the state provided during the person’s lifetime. This is called Medicaid payback. Only after the state is reimbursed can the remaining funds pass to other family members.
Third-Party Special Needs Trusts
Third-party trusts hold assets that never belonged to the disabled person. Parents typically create these trusts as part of their estate planning to provide for a child with disabilities after they’re gone.
You might set up a third-party special needs trust in your will or as a standalone document during your lifetime. You fund it with your own money, either while you’re alive or through your estate after you pass away. Your other children, relatives, or friends can also contribute to this type of trust.
Advantages of Third-Party Trusts
Third-party trusts offer more flexibility:
- No Medicaid payback requirement when the beneficiary dies
- No age limit for establishing trust
- The person creating the trust controls who receives the remaining assets after the beneficiary passes away
- Can be created by anyone, not just specific family members or a court
These differences make third-party trusts the preferred choice for parents doing planning. You maintain control over your assets and decide where leftover funds go after your child no longer needs them.
Which Type Does Your Family Need
Most families doing proactive planning will use a third-party trust. If you’re a parent setting aside money for your child’s future care, this is typically the right choice. You can create it now or through your will, and you avoid Medicaid payback requirements.
First-party trusts serve a different purpose. They’re reactive tools for situations where a disabled person suddenly receives money directly. Personal injury cases are the most common scenario. The settlement belongs to the injured person, so it must go into a first-party trust if you want to preserve benefit eligibility.
Sometimes families need both types. You might have a third-party trust as part of your estate plan, while your adult child also has a first-party trust holding their own settlement funds. Each trust operates independently with its own rules.
Getting the Structure Right
Special needs trust rules are specific and unforgiving. Small mistakes in how you draft or fund these trusts can jeopardize benefits or create tax problems. The distinction between first-party and third-party trusts affects trust language, tax reporting, distribution guidelines, and what happens to funds after the beneficiary’s death.
At Gudeman & Associates, P.C., we work with Michigan families to determine which type of trust fits their situation and draft documents that comply with both federal and state requirements. Our Troy special needs planning lawyer can review your family’s circumstances and explain how these trusts work in practice. Whether you’re planning ahead or responding to an immediate funding need, we’ll help you create a structure that protects benefits while supporting your loved one’s quality of life. Contact our Troy special needs planning lawyer to discuss your family’s planning needs.
