On December 16, 2014 the U.S. Senate approved the Achieving a Better Life Experience ("ABLE") legislation previously approved by the House, authorizing state-sponsored tax-exempt savings programs for disability-related expenses. President Obama is expected to sign the legislation (which is part of the "tax-extenders" bill) before the year is out. Pursuant to the legislation, states may establish ABLE programs under which individuals can set up ABLE accounts in which earnings can accumulate and be distributed on a tax-free basis to pay for the expenses of a disabled beneficiary.
The new Section 529A of the Internal Revenue Code, into which the ABLE provisions will be codified, is modeled on the immediately preceding section, pursuant to which "Section 529" college savings programs have been launched nationwide. The perceived inequity of the existence of tax-favored savings accounts permitting parents and others to save for children's higher education costs but not for the future expenses of children with disabilities produced an increasingly rare consensus in Congress on the enactment of this new tax benefit for individuals. As stated by one of the legislation's co-sponsors: "No longer would individuals with disabilities have to stand aside and watch others use IRS-sanctioned tools to lay the groundwork for a brighter future."
Although the desire to level the playing field, taxwise, for families saving for individuals with disabilities propelled the ABLE statute through a difficult legislative environment, Section 529A is being enacted under budget-neutral requirements requiring offsetting budget cuts to balance out the projected new tax expenditures. This explains various constraints on the funding of Section 529A ABLE accounts that are not present in the case of Section 529 college savings accounts, which were originally authorized as tax-deferred accounts in 1996 and made tax-exempt in 2001.
The substantive provisions of the ABLE legislation, similarities and differences between ABLE programs and Section 529 programs, and additional steps that will be required at the state level before ABLE accounts become available to those anxious to provide for the future of disabled beneficiaries are outlined below.
I. ABLE Programs and Accounts
a. Residency Requirement
Although the legislation authorizes the federal tax benefits associated with ABLE accounts effective January 1, 2015, such accounts only can be accessed through a state-administered program authorized under state legislation. Unlike Section 529 programs, which have no residency limits and therefore can operate as nationwide programs in which states compete with each other based on state tax incentives and the attractiveness of the investment managers and investment options provided by each program, an ABLE account only may be opened in the program established by the state in which the disabled beneficiary resides, or, if such state has not established an ABLE program, in the program of another state with which the beneficiary's state of residence has contracted for the purposes of providing its residents access to an ABLE program.
b. Single Account Requirement
Also in contrast to Section 529, only one ABLE account per beneficiary is permitted. Accordingly, once an ABLE account is established for a particular beneficiary, a subsequent ABLE account established by the same or a different person for the same beneficiary will not qualify for the ABLE tax benefits. An exception is contemplated for account rollovers to a different state's program if a beneficiary changes his or her state of residence, if the beneficiary is changed to another beneficiary residing in a different state or, presumably, if the state of the beneficiary's residence establishes its own ABLE program after having initially contracted out its ABLE program to another state.
c. Contribution Limits
The maximum amount that can be contributed to an ABLE account is the same generous maximum contribution limit applicable to Section 529 college savings accounts; in fact, the statute specifies that the ABLE account limit is the limit established by the applicable state for its Section 529 program. Although Section 529 precludes excessive contributions, it does not provide a specific dollar limit, and the formulas used by each state to determine contribution limits to that state's program vary; many states currently have per beneficiary limits in the range between $300,000 and $400,000.
There are two significant aspects, however, in which the funding of ABLE accounts is restricted relative to the funding of college savings accounts. First, unlike Section 529, Section 529A imposes an annual per account funding limit equal to the annual gift tax exclusion (currently $14,000 per year), which means that it would take several decades of steady annual contributions to build up to the permissible per beneficiary limit.
Second, the per beneficiary limit imposed under Section 529 is measured against accounts opened in a particular state's programs; because Section 529 does not restrict the number of states in which accounts for a particular beneficiary can be established, as a practical matter there is no limit on the amount that can be contributed to Section 529 accounts for a single beneficiary. Because Section 529A limits ABLE accounts for a particular beneficiary to a single account in a single state, both the annual and the lifetime contribution limits for an ABLE account beneficiary are meaningful limits.
Because these limits, particularly the annual limit, put ABLE accounts at a disadvantage relative to Section 529 accounts, and ABLE programs at a disadvantage relative to Section 529 programs due to the likelihood of a smaller asset base against which program administrative expenses can be spread, future pressure on Congress to loosen the annual limit on ABLE account contributions can be anticipated.
d. Account Ownership Requirements
Another structural difference between ABLE accounts and Section 529 college savings accounts is that the ABLE legislation defines "designated beneficiary" as "the eligible individual who established an ABLE account and is the owner of the account", whereas Section 529 permits the account owner to be a different individual (or entity) than the beneficiary. One of the psychologically attractive features of Section 529 accounts is that a parent or other individual can be the account owner, set aside money for the beneficiary and treat the money as transferred to the beneficiary for gift and estate tax purposes, while maintaining total control of the account, including the right, if necessary, to apply the money for the account owner's purposes, rather than the beneficiary's (subject to payment of income taxes and a 10% tax penalty on the withdrawn account earnings.) This unique deemed gift arrangement under Section 529 has given the IRS headaches due to concerns about potential circumvention of transfer taxes.
Perhaps in response to such concerns, the ABLE legislation eliminates for ABLE accounts the distinction between the account owner and the beneficiary, and thus requires an irrevocable transfer to the beneficiary by the funder(s) of the ABLE account. In addition, ABLE accounts are ineligible for the 5-year accelerated gifting provision applicable to 529 accounts.
The requirement that an ABLE beneficiary be the account owner is puzzling, particularly given that many beneficiaries are likely to be minors, and that some of the beneficiaries may not have contracting capacity even when they are adults. This suggests that ABLE accounts may need to be established as UTMA or UGMA accounts or in other forms of individual or corporate custodianship for the account owner/beneficiary.
A related peculiarity is that, as is the case with Section 529 accounts, the ABLE statute permits changes in an account's designated beneficiary to another "member of the family", although for ABLE accounts that term is limited to siblings and step-siblings of the beneficiary, whereas for Section 529 accounts the term includes a much wider menu of relatives. Given that an ABLE beneficiary is also required to be the account owner, it appears that a change in account beneficiary also would require a change in account ownership. Moreover, given that such a change would require direction from the account owner, any such change would seem to require direction by the original account owner/beneficiary or by some other individual with power of attorney for the original account owner/beneficiary. This is an area in which regulatory or other guidance is likely to be required.
An additional peculiarity is that the ABLE legislation attempts to provide some bankruptcy protection to ABLE accounts, as is provided for Section 529 accounts. However, the language protecting ABLE accounts protects ABLE account assets "only if the designated beneficiary of such account was a child , stepchild, grandchild, or stepgrandchild of the debtor." This language makes sense in the context of Section 529, where the "debtor"/account owner typically is a different individual than the beneficiary. In the case of an ABLE account, where the beneficiary is required to be the account owner, the language offers no protection for a bankruptcy by the account owner/beneficiary, as, notwithstanding some well-known song lyrics, the beneficiary cannot be his or her own child or grandchild.
e. Eligibility Requirements
Under the ABLE legislation, the beneficiary of an ABLE account must be an "eligible individual" at the time the account is established, at the time of any contribution to the account and at the time of a distribution for qualified disability expenses. Eligibility is required to be redetermined for each tax year. To be eligible, an individual must have been determined to be disabled prior to age 26.
There are two ways of satisfying the disability determination. First, an individual meets the eligibility requirement if during the applicable tax year the individual is entitled to Social Security Act benefits based on blindness or disability that occurred before the individual reached age 26. Alternatively, the eligibility requirement can be satisfied if (i) a certification is filed on behalf of the individual for the applicable tax year with the Treasury Secretary, certifying that the individual is blind or has a physical or mental impairment which results in severe functional limitations and which has lasted or is expected to last for a a continuous period of at least 12 months or can be expected to result in death, (ii) the certification attests that such blindness or disability occurred prior to age 26 and (iii) the certification includes a diagnosis of the relevant impairment signed by a qualified physician.
The ABLE legislation does not specify what happens if an individual is eligible at the time an account is established and at the time of contributions and distributions, but there are intervening years in which the annual eligibility determination was not made or documented. Regulatory guidance will be needed on whether there is a deemed termination of the ABLE account in the first year in which eligibility is not determined, or a less draconian result.
f. Qualified Disability Expenses
As with Section 529 accounts, earnings in an ABLE account build up on a federally tax-free basis, and distributed earnings remain tax-free to the extent they do not exceed the beneficiary's qualified expenses in the applicable tax year. For an ABLE account, "qualified disability expenses" is defined broadly as "any expenses related to the eligible individual's blindness or disability which are made for the benefit of an eligible individual" and includes expenses for education, housing, transportation, employment training and support, assistive technology and personal support services, health, prevention and wellness, financial management and administrative services, legal fees, oversight and monitoring, funeral and burial and other expenses approved by the Treasury Secretary.
The earnings portion of distributions from an ABLE account that exceed an eligible beneficiary's qualified disability expenses is subject to federal income tax and, unless the distribution follows the beneficiary's death, a 10% additional tax.
g. Investment Direction
The ABLE legislation permits an account beneficiary to direct the investment of contributions to the account twice a year. (The ABLE legislation also amends Section 529 to permit such twice a year investment direction for Section 529 college savings accounts.) Assuming that the IRS interprets the ABLE statute in a manner similar to its interpretation of the investment direction provisions in Section 529, ABLE account beneficiaries will be able to redirect existing account balances among the ABLE program's investment options twice per year, and will be able to direct the investment of any new contributions at the time the applicable contribution is made. Again, because the ABLE beneficiary may be a minor or have a disability that precludes investment decisions, a person with power of attorney to make such investment decisions on the beneficiary's behalf may be required.
h. Effect on Eligibility for Means-Tested Programs
Aside from availability of funds for savings purposes, a frequent impediment to saving for a dedicated purpose such as higher education expenses or disability expenses is the perception that such savings may reduce the amount of available funding from other sources, such as financial aid in the case of college savings accounts and federal or state disability assistance in the case of disability savings accounts. The ABLE legislation addresses this issue by generally excluding ABLE account balances and distributions from being counted for purposes of means-tested federal programs.
There are two exceptions relating to the Supplemental Security Income (SSI) program: distributions from an ABLE account for housing expenses are not excluded, and the excess of an ABLE account balance over $100,000 is counted and may result in the suspension of SSI benefits during any period in which such excess amount remains in the ABLE account. Even if SSI benefits are suspended due to an ABLE account balance in excess of $100,000, the beneficiary's Medicaid eligibility is not impacted by such suspension.
i. State Reimbursement Claim upon Beneficiary's Death
Upon the death of an ABLE account beneficiary, a state that has paid for the beneficiary's medical costs incurred after the account was established may claim reimbursement from any balance in the ABLE account for such payments, net of any premiums paid on the beneficiary's behalf to a Medicaid Buy-In program. The 10% income tax surcharge is inapplicable to any such distribution to a state.
j. ABLE Program Verification and Reporting Requirements
Under Section 529A, a state establishing an ABLE program is not required to verify the eligibility of a beneficiary for whom an ABLE account is opened; that appears to be between the beneficiary and the IRS, subject to any regulations that may be promulgated by the Treasury Secretary. Similarly, as is the case with Section 529 programs, an ABLE program is not required to determine whether distributions are qualified for tax-exemption or taxable. However, an ABLE program must report to the Treasury Secretary, at the time an ABLE account is established, the name and state of residence of the beneficiary, and must report on a monthly basis to the Commissioner of Social Security distributions from and account balances for each ABLE account.
Section 529A permits the Treasury Secretary to adopt regulations "providing for the information to be presented to open an ABLE account", among other topics. The Treasury Secretary may also require the state sponsor of an ABLE program to report to the Treasury Secretary and account beneficiaries "with respect to contributions, distributions, the return of excess contributions, and such other matters as the Secretary may require."
II. Getting ABLE Programs Off the Ground
a. State ABLE Legislation
The enactment of Section 529A will authorize the establishment of ABLE programs effective January 1, 2015, but ABLE accounts will not be available to families anxious to take advantage of tax-exempt savings for disabled beneficiaries until the beneficiary's state of residence launches an ABLE program or enters into a contract with another state permitting its residents to use an ABLE program launched by the other state. A state is likely to require legislation authorizing a particular state agency or instrumentality to establish and administer an ABLE program, and it is also likely that legislative authorization would be required for a state to contract with another state for resident access to the other state's ABLE program. Some states have already passed ABLE legislation in anticipation of the enactment of the federal tax benefit, but many states still need to do so before their residents can access the new tax benefit.
States that have not yet enacted ABLE legislation will need to determine whether the authority to launch and operate the state's ABLE program should be granted to the state agency or instrumentality responsible for the state's 529 college savings program, or to a different entity. Given the similarities between Section 529A and Section 529, there appear to be obvious efficiencies in consolidated administration of such programs. On the other hand, disability advocates may prefer administration of ABLE programs by state officials or boards with expertise in disability matters, even though the duties of ABLE program administrators are primarily investment-oriented. Some states may elect to provide their Section 529 and Section 529A programs under the same roof, but include individuals with disability expertise on the applicable board or advisory council.
b. Program Managers and Investment Options
The consensus around the desirability of ABLE programs suggests the existence of substantial pent-up demand for investing in such programs. However, the current $14,000 per year contribution limit, and an ABLE program's inability, with the limited exception of the "contracting state" provision, to attract out of state residents, are likely to result in a much longer ramp-up period for ABLE programs than for the more successful 529 programs, and smaller amounts of assets under management. States establishing ABLE programs will need to evaluate the pros and cons of lumping their 529 and 529A programs together for purposes of program management contracts and other potential administrative cost efficiencies inherent in combining the two asset pools operationally, while segregating them for legal and tax purposes.
Similarly, states establishing ABLE programs and their investment managers will need to consider the efficiency of offering similar investment options and underlying investments in their ABLE programs and college savings programs. One obvious adjustment that will need to be made is in age-based options, the most popular options under 529 programs, in which investments follow an increasingly conservative investment glide path as the account beneficiary approaches presumed college age. Age-based options may also be useful in ABLE programs, but considerable financial tinkering will be required to make them appropriate for expenditures over a disabled beneficiary's lifetime versus the much narrower higher education window. The fact that many ABLE accounts are likely to be fiduciary or custodial accounts rather than accounts in which the account owner owes no fiduciary duty to the account beneficiary may also influence the investment line-up offered by ABLE programs.
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