Most families with a Special Needs Trust have never looked at its tax return. They have no reason to — the trustee files it, the tax is paid from trust assets, and the beneficiary's life continues as planned. But if you compare the trust's effective tax rate to a comparable individual's, a gap opens up that, compounded over 40 years, can consume a meaningful percentage of the trust principal.
The Compressed Trust Bracket
For tax year 2025, a non-grantor trust reaches the top federal ordinary-income bracket of 37% at approximately $15,200 of retained income. The top long-term capital-gains bracket of 20% kicks in at approximately $14,450. By comparison, an individual taxpayer does not reach the 37% ordinary bracket until approximately $609,000 of taxable income and does not reach the 20% capital-gains bracket until approximately $518,900.
The practical effect: a trust holding a portfolio generating $100,000 of retained income pays approximately $34,000 in federal income tax. A single individual with the same $100,000 of taxable income pays approximately $17,000. Same income, nearly double the tax, entirely because of how the trust bracket is structured.
Why This Matters Specifically for SNTs
A Special Needs Trust has a specific structural feature that intensifies the bracket problem: because the trustee is discouraged from distributing funds directly to the beneficiary in ways that would count as income for SSI or Medicaid purposes, the trust frequently retains income that a more flexible trust might distribute out to a lower-bracket beneficiary. The compressed bracket sits on top of that retention pattern and multiplies the tax drag.
Over a 40-year trust term, that tax drag can reduce the trust's purchasing power by 15 to 25 percentage points versus what it would have been at individual-level tax rates. For a trust funded at $2 million with the intent to support a beneficiary for their lifetime, that difference can translate into hundreds of thousands of dollars in lost capacity.
The Three Design Levers
There are three main structural choices an SNT drafter can use to mitigate the compressed-bracket problem, and they can — and should — be combined.
One: grantor-trust status during the grantor's life. A third-party SNT can be drafted so that the grantor (usually a parent) is treated as the tax owner for income-tax purposes during the grantor's lifetime. The trust's income is reported on the grantor's return, at the grantor's individual brackets, and the grantor pays the tax. This is both a tax-saving technique and a silent additional gift — the grantor is effectively making an ongoing tax-free transfer to the trust beneficiaries by paying their tax from outside the trust. Grantor-trust status typically terminates at the grantor's death, at which point the trust becomes non-grantor. But many years of tax arbitrage can be captured during the grantor's life.
Two: careful asset selection for the trust portfolio. Not every investment is equally tax-inefficient in a trust. Municipal bonds generate federally tax-exempt interest. Stocks that do not pay dividends generate deferrable gain. Real estate in a well-structured partnership can use depreciation to shelter cash flow. Meanwhile, dividend-heavy equities, REITs, and actively managed taxable mutual funds are relatively bad fits for compressed-bracket trust portfolios. A thoughtful asset-location strategy across the family's taxable, retirement, and trust accounts can meaningfully reduce the trust's ordinary-income exposure.
Three: DNI planning. Distributable Net Income (DNI) is the mechanism by which trust income carries out to beneficiaries when distributed. A trust that distributes out its DNI shifts the tax from the compressed trust brackets to the beneficiary's (usually much lower) individual brackets. For an SNT, straight distributions of cash to the beneficiary often do not work — they can disqualify benefits. But distributions directly to third-party providers for the beneficiary's qualified expenses can still carry DNI to the beneficiary's return and be taxed at individual rates, even though the beneficiary never holds the cash. This is a drafting and administration subtlety that many SNT trustees get wrong.
The Practical Integration
In practice, a well-designed SNT combines all three: grantor-trust status during the parent's lifetime, a tax-efficient asset allocation within the trust, and a distribution pattern that uses DNI to shift income to the beneficiary where benefit rules allow. Done together, these techniques can cut the effective tax burden on the SNT by 30% to 50% versus a naively structured trust.
None of this is in the SNT template. It has to be drafted in on the front end and administered thoughtfully on the back end. It is, specifically, the reason the tax background I bring to special-needs planning is not a detail — it is the thing that keeps the trust doing what the family built it to do over the child's whole life.
Carla Alston holds a Master of Laws in Taxation from New York University School of Law. She leads special needs planning and tax-smart estate planning at WG Law. Schedule a consultation.