First-Party vs. Third-Party Special Needs Trusts: Key Differences Explained

For parents and caregivers of children or adults with disabilities, financial planning is more than just a matter of managing money, it’s about ensuring a lifetime of care and security. A misstep in planning can mean the difference between preserving access to government benefits and unintentionally disqualifying a loved one from vital support like Supplemental Security Income (SSI) or Medi-Cal.

This is where special needs trusts (SNTs) come in. They are powerful tools designed to protect benefits while providing supplemental financial resources. But not all special needs trusts are the same. Families often face the choice between establishing a first-party trust or a third-party trust, and choosing the wrong one can have long-lasting consequences.

Let’s break down what these trusts are, how they differ, and when each type makes sense.

What Is a Special Needs Trust and Why It’s Essential

A special needs trust is a legal arrangement that allows funds to be set aside for a person with disabilities without interfering with their eligibility for means-tested benefits. Programs like SSI and Medi-Cal have strict financial limits: if the individual owns too much in assets or receives money outright, they could lose their benefits.

By placing funds into a properly structured special needs trust, families can:

• Maintain access to government programs.
• Provide for extra needs such as education, travel, therapies, or recreation.
• Protect assets from mismanagement or exploitation.

Why it matters: without a trust, even a modest inheritance or personal injury settlement could immediately disqualify someone from crucial assistance.

What Is a First-Party Special Needs Trust?

A first-party special needs trust is funded with the disabled individual’s own assets. These assets may come from:

• A personal injury settlement.
• An inheritance received directly.
• Accumulated savings or property in the individual’s name.

Because the trust uses the beneficiary’s money, federal law requires specific rules:

• The trust must be established by a parent, grandparent, legal guardian, or court.
• The beneficiary must be under 65 when the trust is created.
• Upon the beneficiary’s death, any remaining funds must first be used to repay Medicaid or Medi-Cal for benefits provided during their lifetime.

In other words, first-party trusts offer protection but carry a payback requirement.

Scenario example: A young adult with disabilities receives a $300,000 court settlement after an accident. Without a first-party special needs trust, those funds would disqualify them from SSI and Medi-Cal. By placing the settlement into a trust, they keep their benefits while still accessing the money for supplemental needs.

What Is a Third-Party Special Needs Trust?

A third-party special needs trust is funded with assets that never belonged to the disabled person. Instead, family members or friends create and fund the trust for the benefit of their loved one. Common funding sources include:

• A parent’s or grandparent’s estate plan.
• Gifts during the family’s lifetime.
• Proceeds from life insurance policies.

Unlike a first-party trust, a third-party trust does not have a Medicaid payback requirement. This means that when the beneficiary passes away, remaining assets can be distributed to other family members or charities according to the trust’s instructions.

Scenario example: Parents of a child with autism want to leave $500,000 from their estate to provide lifelong care. By creating a third-party special needs trust, they ensure their child benefits from the funds without jeopardizing SSI or Medi-Cal, and any unused funds can later go to siblings.

Key Differences Between First-Party and Third-Party Trusts

While both trusts serve the same purpose, protecting benefits and providing supplemental support, the rules and outcomes differ significantly.

Funding Source

• First-Party: Beneficiary’s own assets (settlements, inheritance, savings).
• Third-Party: Assets from parents, relatives, or others.

Creation Rules

• First-Party: Must be set up by a parent, grandparent, guardian, or court before the beneficiary turns 65.
• Third-Party: Can be set up at any time by almost anyone.

Payback Requirement

• First-Party: Must repay Medi-Cal/Medicaid upon the beneficiary’s death.
• Third-Party: No repayment requirement; funds can go to other heirs.

Flexibility

• First-Party: Restricted by federal rules.
• Third-Party: More flexibility in design and distribution after the beneficiary’s lifetime.

By understanding these distinctions, families can avoid costly mistakes and align their planning with both legal requirements and family goals.

When Families Should Choose One Type Over the Other

Choosing between a first-party and third-party special needs trust often depends on the source of funds and the long-term goals of the family.

• Use a first-party trust when:
  • The disabled person receives a direct inheritance not protected by estate planning.
  • A personal injury settlement or insurance payout is awarded to the individual.
  • The beneficiary already owns assets that exceed benefit limits.
• Use a third-party trust when:
  • Parents or relatives want to leave money for a child with disabilities without affecting benefits.
  • Families want to ensure remaining funds are passed to siblings or other heirs.
  • A comprehensive estate plan includes long-term special needs protection.

Case in point: Imagine two siblings in different situations. One inherits $100,000 directly from a grandparent, requiring a first-party trust to avoid benefit disruption. The other sibling’s parents plan ahead by funding a third-party trust through life insurance, ensuring no Medi-Cal payback is required later.

The best approach is often to use both types of trusts strategically depending on circumstances. An elder law or special needs planning attorney can guide families through the decision-making process to ensure compliance and maximum benefit.

Conclusion: The Right Trust Ensures Lifelong Security

Special needs planning is about more than legal documents, it’s about ensuring a loved one has security, dignity, and opportunities for a fulfilling life. The choice between a first-party and third-party special needs trust is not one-size-fits-all. It depends on where the money comes from, what protections are needed, and what goals the family wants to achieve.

With careful planning, families can protect government benefits, safeguard assets, and create peace of mind for both the present and the future. The most important step is starting early and working with a qualified special needs trust attorney who understands California law and the unique challenges your family faces. Book a free call with Amy Hsiao today.