Funeral Trust

A funeral trust is a trust holding funds committed to a person's funeral, burial or cremation expenses, with a funeral provider as the eventual payee. Most are created because state law requires money paid under a preneed funeral contract to be held somewhere the provider cannot simply spend it, and a trust is one of the two common places, the other being an assigned life insurance policy. The trust and the contract are different documents doing different jobs: the contract says what will be provided, and the trust holds the money until it is. Some funeral trusts are funded without any contract at all, purely to set money aside.

Revocable or irrevocable is the whole question, and it is answered by state law rather than by the trust document alone. A revocable funeral trust can be unwound and the money recovered, so for every purpose that asks what a person owns, they still own it. An irrevocable one cannot, which is what makes it useful to someone applying for a means-tested program and what makes it a one-way door for everyone else. Social Security's own operating manual is explicit that the classification is not the trust's to declare: "State law determines whether a contract is revocable. Some burial contracts may be partly revocable. For example, if the total value of an otherwise irrevocable contract exceeds the limit set for irrevocability by State law, the excess is revocable." That instruction assumes a state may set its own limit on how much can be made irrevocable, and where one exists it is a number that has to be looked up in the applicable state.

The Supplemental Security Income rules are federal, and they are more detailed than most summaries suggest. Three separate exclusions interact. Burial spaces come first: 20 CFR 416.1231(a)(1) excludes the value of burial spaces for the individual, their spouse and immediate family, with no dollar limit, and the definition reaches plots, crypts, urns, niches, vaults, headstones, markers and the cost of opening and closing the grave.

Burial funds are separate and are capped: 416.1231(b)(1) excludes "an amount not in excess of $1,500 each of funds specifically set aside for the burial expenses of the individual or the individual's spouse." That figure is a regulatory literal rather than an inflation-adjusted amount, and the section has not been amended since 1992. The condition attached to it is strict and catches people: the exclusion "applies only if the funds set aside for burial expenses are kept separate from all other resources not intended for burial of the individual (or spouse) and are clearly designated as set aside for the individual's (or spouse's) burial expenses. If excluded burial funds are mixed with resources not intended for burial, the exclusion will not apply to any portion of the funds." Not the excess portion. Any portion. Paragraph (b)(3) then defines burial funds to include "revocable burial contracts, burial trusts, other burial arrangements ... cash, accounts, or other financial instruments with a definite cash value clearly designated for the individual's (or spouse's, if any) burial expenses and kept separate from nonburial-related assets."

The third rule is a reduction, and it is the one that surprises people. Paragraph (b)(5) provides that each person's $1,500 exclusion "must be reduced by" the face value of excluded life insurance policies on that person and by "Amounts in an irrevocable trust (or other irrevocable arrangement) available to meet the burial expenses." Social Security's operating manual states the same thing from the other direction: if a burial contract cannot be revoked and cannot be sold without significant hardship, it is not a resource, but "any portion of the contract that represents burial funds reduces the $1,500 otherwise available for the burial funds exclusion," while "any portion that represents the purchase of burial spaces has no effect on the burial funds exclusion."

So an irrevocable funeral trust does two things at once. It removes itself from the resource count, which is the point of making it irrevocable. And it uses up the separate $1,500 allowance, so a person who has already funded an irrevocable arrangement generally has no burial-funds exclusion left for a savings account earmarked for the same purpose. Splitting the arrangement between burial spaces and burial services matters for the same reason: the spaces do not consume the allowance and the services do.

Two further points from the operating manual are worth knowing. Buying a preneed arrangement is treated as a purchase rather than a transfer, so where an individual contracts with a provider and the provider places the funds in trust, that is not a transfer of resources for the SSI rules. And Social Security draws the same line this page does: prepaid burial contracts "do not include burial insurance ... or burial trusts," which are separate categories with their own instructions.

Medicaid is a different question and the answer is state law. Medicaid resource rules are administered by the states, and how a particular state treats an irrevocable funeral trust, and how much may be made irrevocable, has to be checked in that state. Nothing above should be read as a statement about any state's Medicaid program.

The income tax election, which is what "qualified funeral trust" means. Left alone, a trust holding a purchaser's preneed money would be treated as owned by the purchaser, so the interest earned each year would land on the purchaser's own return. Internal Revenue Code section 685 offers an alternative. Section 685(b) defines a qualified funeral trust as a domestic trust that arises from a contract with someone in the business of providing funeral or burial services, whose sole purpose is to hold and invest funds and use them for those services, whose only beneficiaries are the individuals for whom the services are to be provided at death, whose only contributions come from or for those beneficiaries, whose trustee elects the treatment, and which would otherwise be treated as owned by the purchasers.

Two consequences follow. Under section 685(c), "Section 1(e) shall be applied to each qualified funeral trust by treating each beneficiary's interest in each such trust as a separate trust," so a provider's single pooled trust is taxed as though it were many small ones rather than one large one, which matters because the trust rate schedule reaches its top rate at a low level of income. And under section 685(a) subparts B, C, D and E do not apply to the trust at all, and no deduction is allowed under section 642(b). Section 685(d) adds that a purchaser who cancels recognizes no gain or loss on the refund. Congress removed the dollar limit on contributions to such a trust in 2008, so there is no federal ceiling on how much can go in.

1. The money is committed, usually by signing a preneed contract with a funeral provider and paying for it, though a trust can also be funded on its own.

2. It goes into a trust rather than to the provider, with a trustee holding it. State law generally requires this, and the terms of the trusting arrangement are set by that state's rules rather than by the buyer.

3. Revocable or irrevocable is chosen, subject to any state limit on how much may be made irrevocable. This is the decision that determines the means-tested treatment.

4. The trustee may elect qualified funeral trust status under section 685, which changes who reports the trust's income and how it is taxed.

5. The trust invests and accumulates until the death it was funded for.

6. The provider is paid for what was actually furnished, and what happens to any remainder is set by the contract and by state law.

A hypothetical showing what section 685(c) does. A funeral home's single trust holds interests for 40 purchasers who each paid $12,000, so the trust holds $480,000. It earns 4 percent in interest for the year, which is $19,200. Taxed as one trust, that $19,200 would run up a rate schedule that reaches its top bracket at a very low level of income, so most of it would be taxed near the top. With the qualified funeral trust election, section 685(c) applies the rate schedule to each beneficiary's interest as a separate trust, so the calculation is done on $19,200 divided by 40, or $480 per beneficiary, and each of those small amounts sits at the bottom of the schedule. The election also costs the trust the section 642(b) deduction, and the purchasers no longer report the income on their own returns. All figures here are invented to show the arithmetic, and the actual rate schedule is set annually.

What a funeral trust does

• It separates the money from the funeral provider's own funds, so a provider's failure is not automatically the family's loss.
• Made irrevocable, it converts countable savings into an arrangement a means-tested program does not count as a resource.
• It removes a set of decisions and a bill from a family at the worst possible moment.
• The qualified funeral trust election lets a provider's pooled trust be taxed as many small trusts, and takes the annual income off the purchaser's own return.
• A purchaser who cancels recognizes no gain or loss on the refund under section 685(d).

What it costs

• Irrevocability is permanent. The money cannot come back for a different emergency, and a state may cap how much of it can be made irrevocable at all.
• An irrevocable arrangement uses up the separate burial-funds exclusion, so a person who funds one generally has no allowance left for an earmarked savings account.
• The burial-funds exclusion is destroyed entirely, not merely reduced, if the funds are mixed with money not intended for burial.
• The money is usually committed to one provider through the contract that created the trust, so a move or a business closure is a real problem, and that problem belongs to the contract rather than to the trust.
• The regulatory exclusion amount is not indexed for inflation, so its real value falls every year.
• Growth inside the trust may not keep pace with the cost of what it is meant to buy, unless the underlying contract guarantees the price.