Tax Results When Account Beneficiary Passes Away

Upon the death of an ABLE account’s designated beneficiary, the remaining account balance is first paid out to cover any outstanding qualified disability expenses of the designated beneficiary.

Next, any remaining balance — net of any premiums paid from the account to a Medicaid Buy-In program — is paid to reimburse the state Medicaid plan for medical assistance paid for the designated ABLE account beneficiary after the account was established. But that payout happens only if the state files a claim for such reimbursement.

Important: Because of this payback provision, it may be advisable to keep only a limited amount of funds in an ABLE account. Additional funds can be kept in a special needs trust that isn’t subject to any payback provision.

Any remaining balance is distributed to the estate of the deceased designated ABLE account beneficiary or other beneficiary named to receive account funds after the death of the designated beneficiary. To the extent such post-death distributions consist of ABLE account earnings, they’re included in the recipient’s income for federal income tax purposes, but no penalty tax is owed.

November 19, 2020

The Achieving a Better Life Experience (ABLE) Act of 2014 allows states to set up ABLE account programs, which are similar to state-run Section 529 college savings programs. That is, you can establish a tax-favored ABLE account to cover qualified disability expenses of a family member or loved one who’s named as the designated account beneficiary. Here’s how you can take advantage of this tax-advantaged opportunity.

The Basics

You can set up an ABLE account under a qualified ABLE program that’s established and maintained by a state or state agency. Earnings from ABLE account investments can accumulate federal-income-tax-free, and tax-free withdrawals can be taken to pay qualified expenses for the account beneficiary. So, this is a tax-smart way to save for and pay expenses for loved ones with disabilities.

The IRS ground rules are as follows:

  • Only cash contributions are allowed.
  • The annual contribution limit is the same as the annual federal gift tax exclusion. For 2020, the gift tax exclusion is $15,000. It’s periodically increased for inflation, but only in $1,000 increments. So, the exclusion for 2021 will almost certainly remain at $15,000. In turn, the general contribution limit for ABLE accounts for 2021 will almost certainly remain at $15,000.
  • For 2018 through 2025, a designated ABLE account beneficiary can contribute an additional amount based on his or her compensation or self-employment income. More on that option later.
  • The investment direction of an ABLE account can be changed as often as twice in each calendar year.
  • You can establish and contribute to an ABLE account under any state’s ABLE program, regardless of where you live or where the designated account beneficiary lives.

Except for the limitation on contributions, these tax-law guidelines are very similar to those for Section 529 college savings accounts.

Eligible Beneficiaries

A designated ABLE account beneficiary must be an eligible individual for the tax year. The following categories of individuals are eligible:

  • People who are entitled to benefits based on blindness or disability under the Social Security disability insurance program or the Supplemental Security Income (SSI) program, and that blindness or disability occurred before age 26, and
  • People who have filed disability certifications with the IRS or signed physician’s diagnoses, stating that 1) the individual has a medically determinable physical or mental impairment that causes marked and severe functional limitations and that can be expected to result in death, or that has lasted or can be expected to last for a continuous period of at least 12 months, or is blind, and 2) the disability or blindness occurred before the individual reached age 26.

The before-age-26 requirement eliminates the possibility of setting up ABLE accounts for individuals who become blind or disabled later in life.

Tax Treatment of Contributions

Contributions to an ABLE account aren’t deductible for federal income tax purposes. However, state income tax benefits may be available.

Contributions must be made in cash, and any person can contribute for the benefit of the designated account beneficiary. There are no income limits for the account beneficiary or the contributor. Even billionaires can contribute.

Total contributions to a designated beneficiary’s ABLE account in a year are generally limited to the annual federal gift tax exclusion for that year. For 2020, the exclusion amount is $15,000. However, in 2018 through 2025, additional amounts can potentially be contributed, thanks to a Tax Cuts and Jobs Act (TCJA) provision. Under that provision, the annual limit on ABLE account contributions is increased for 2018 through 2025. Once the general contribution limit has been reached ($15,000 for 2020), the designated ABLE account beneficiary can himself or herself contribute an additional amount up to the lesser of:

  • The applicable federal poverty line for a one-person household for the prior year, or
  • The designated beneficiary’s compensation for the contribution year.

For the 48 contiguous states and Washington, D.C., the 2019 poverty line for a one-person household was $12,490.

Important: For the account beneficiary to be eligible for the additional contribution privilege for the year, no contributions can have been made on behalf of the account beneficiary to a defined contribution qualified retirement plan, such as a 401(k) or profit-sharing plan.

Thanks to another TCJA provision, there’s an additional bonus that can potentially be claimed: Contributions made by the designated ABLE account beneficiary to his or her account in 2018 through 2025 are potentially eligible for a federal income tax credit known as the retirement savings contributions credit or, more simply, the “saver’s credit.”

In general, an ABLE account beneficiary is potentially eligible for the saver’s credit if he or she:

  • Is age 18 or older,
  • Isn’t claimed as a dependent on another person’s individual income tax return, and
  • Isn’t a student.

The credit can be up to 50% of the ABLE account contribution, subject to a credit maximum of $1,000.

Hypothetical Example

Let’s say Ben is a blind individual who’s the designated beneficiary of an ABLE account. He lives in Georgia. In 2020, he’s employed and earns $20,000 in wages for the year. No retirement plan contributions are made on Ben’s behalf for the year.

In 2020, Ben’s parents contribute the general maximum of $15,000 to his ABLE account. Ben himself can make an additional 2020 contribution of up $12,490. That is the lesser of:

  • His $20,000 of compensation for 2020, or
  • The $12,490 federal poverty line for a one-person household for 2019.

Ben must make any additional contribution for his 2020 tax year by December 31, 2020.

In addition, Ben can potentially claim a saver’s credit of up to $1,000 for 2020, based on his 2020 contributions to his ABLE account.

Tax Treatment of Distributions

Distributions from ABLE accounts are federal-income-tax-free to the extent that they don’t exceed the designated beneficiary’s qualified disability expenses for the year. Qualified disability expenses are any expenses related to the designated account beneficiary’s blindness or disability, including:

  • Education,
  • Housing,
  • Transportation,
  • Employment training and support,
  • Assistive technology and personal support services,
  • Health, prevention and wellness services,
  • Financial management and administrative services,
  • Legal fees,
  • Expenses for oversight and monitoring,
  • Funeral and burial expenses, and
  • Other expenses that are specified by IRS regulations.

As you can see, these outlays include basic living expenses and aren’t limited to expenses for which there’s a medical necessity or expenses that solely benefit the designated account beneficiary.

Tax Treatment of Nonqualified Distributions

Distributions in excess of the designated account beneficiary’s qualified disability expenses are included in the account beneficiary’s gross income. They’re also hit with a 10% penalty tax. The amount included in gross income is based on the ratio of nonqualified distributions for the year to total distributions for the year.

In effect, when distributions for the year exceed qualified disability expenses, the distributions are treated as consisting of: 1) a pro-rata tax-free return of principal amount from account contributions, and 2) a pro-rata taxable amount from accumulated account earnings.

More Details

There are several other key rules that you should understand when deciding whether to set up an ABLE account for a loved one, including:

Investment options. State-run ABLE programs generally offer investment options similar to those offered by state-run 529 college savings plans. For example, you may be able to select an “aggressive growth” portfolio consisting of mutual funds from well-known providers, a “moderate growth” portfolio or a “conservative income” portfolio. You can change an ABLE account’s investment direction as often as twice in each calendar year.

Rollovers. ABLE account distributions can be rolled over federal-income-tax-free within 60 days to another ABLE account for the benefit of the designated beneficiary or an eligible individual who’s a member of the designated beneficiary’s family, as defined.

Beneficiary changes. You can change an ABLE account’s designated beneficiary federal-income-tax-free, as long as the new beneficiary is an eligible individual who’s a family member of the original beneficiary.

Reap the Benefits

It’s probably fair to say that ABLE accounts have been underappreciated and underutilized compared to 529 accounts. An ABLE account can be a helpful financial planning tool to help a family member or loved one with a disability. Contact your tax professional to discuss the pros and cons of setting one up before year end.

 

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