When creating a special needs trust, one of the most important — and often misunderstood — decisions is choosing the correct type of trust. While the term “special needs trust” is commonly used as a catch-all, there are actually two primary types: first-party and third-party special needs trusts. Each serves a different purpose and is used in different circumstances, with serious consequences for getting it wrong.
In this article, we’ll break down the key differences between these two trusts and explain how to determine which one best fits your family’s special needs planning strategy.
A special needs trust (SNT) is a legal tool used to hold and manage assets for the benefit of an individual with disabilities. The purpose of the trust is to improve the beneficiary’s quality of life without disqualifying them from essential needs-based government programs like Supplemental Security Income (SSI) or Medicaid.
These trusts allow a trustee to use funds for expenses not covered by public benefits — such as transportation, education, recreation, and personal care — while protecting eligibility for critical support services.
A first-party special needs trust is funded with the beneficiary’s own money. This might come from an inheritance received outright, a personal injury settlement, back payment from Social Security, or accumulated savings.
Because these funds legally belong to the individual with disabilities, federal law mandates that the trust include a Medicaid payback provision. This means that when the beneficiary passes away, any money left in the trust must first be used to reimburse Medicaid for the cost of care provided during their lifetime.
This type of trust is often established as a reactive measure — for example, when someone unexpectedly receives money that would otherwise disqualify them from means-tested benefits. The trust can be set up by the beneficiary themselves (if mentally competent and over age 18), or by a parent, grandparent, guardian, or court.
A third-party special needs trust is funded with assets that never legally belonged to the beneficiary. These funds typically come from a parent, grandparent, or other loved one as part of a gift, estate plan, or life insurance policy.
The key advantage of a third-party trust is that it does not require a Medicaid payback clause. After the beneficiary passes away, any remaining assets can be passed on to other family members, charities, or future beneficiaries — entirely at the discretion of the trust creator.
This type of trust is usually created as a proactive planning tool. It can be established during the parents’ lifetime or through a will or living trust, and it offers greater flexibility and long-term control.
While both types of special needs trusts serve to protect public benefits, they differ significantly in structure, purpose, and outcome. Here's a quick comparison:
Choosing the wrong trust — or failing to plan at all — can have serious consequences. A well-intentioned family member may leave an inheritance directly to a person with disabilities, unintentionally disrupting their benefits. Or a parent might use a first-party trust when a third-party option would offer more flexibility and legacy protection.
Even small missteps can result in lost benefits, delayed access to funds, legal complications, and unnecessary court involvement. That’s why it’s critical to work with a qualified professional who understands the complexities of special needs planning.
Families who plan ahead often find they have more options, better control, and fewer legal hurdles. A third-party special needs trust can be funded gradually with gifts or coordinated with life insurance policies. It can be customized with specific instructions, successor trustees, and even oversight roles like trust protectors.
On the other hand, when families wait until there’s a crisis or windfall, the only choice may be a first-party trust, which comes with stricter rules and fewer options for preserving assets.
Both first-party and third-party special needs trusts are essential tools for protecting a loved one’s financial future — but they aren’t interchangeable. Understanding the difference allows families to make informed decisions, avoid costly mistakes, and ensure long-term stability for individuals with disabilities.
If you’re unsure which type of trust your family needs, consult with a special needs planning attorney who can guide you through the process and help you build a strategy that reflects your values, your resources, and your loved one’s needs. Want to dive deeper? Watch our webinar on the top mistakes in special needs planning.
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