Set up a Tax-Favored ABLE Account for a Family Member with a Disability

Today, most states offer programs that allow you to establish a tax-favored account to cover the qualified expenses of a family member with a disability. These programs were authorized under the Achieving a Better Life Experience (ABLE) Act of 2014, and Congress has subsequently passed legislation that sweetens the deal. Read on to learn how ABLE accounts work and the tax advantages they can deliver.  

The Basics

An ABLE account must be set up under a qualified ABLE program that's established and maintained by a state, state agency or instrumentality that meets tax-law requirements that are similar to the requirements for Section 529 college savings plans. You can establish an ABLE account under any state's program, regardless of where the designated account beneficiary lives.

The designated beneficiary of an ABLE account is defined as an eligible individual who's deemed to be the account owner. An eligible individual can have only one ABLE account established on his or her behalf.

An individual is eligible for a tax year if:

1. A disability certification for the individual has been filed with the IRS for the year, or
2. The individual is entitled to benefits for the year based on blindness or disability under the Social Security disability insurance program or the Supplemental Security Income program, and that blindness or disability has occurred before the individual reaches age 26.

Important: Starting in 2026, the age will be increased to 46, which will allow ABLE accounts to be set up for individuals who become blind or disabled later in life.

What if the designated beneficiary is unable to exercise signature authority over his or her ABLE account or chooses to not exercise signature authority? In that case, references to the designated beneficiary with respect to his or her actions include actions by the person with signature authority over the account.

State-run ABLE programs generally offer investment options similar to those offered by state-run 529 college savings plans. For example, you may be able to select an aggressive-growth portfolio consisting of mutual funds from well-known providers, a moderate-growth portfolio or a conservative-income portfolio. An ABLE account's investment direction can be changed as often as twice each calendar year.

Tax Treatment of ABLE Account Contributions

Contributions to ABLE accounts aren't deductible for federal income tax purposes. Contributions must be made in cash. Any person can make an ABLE account contribution for the benefit of the designated account beneficiary, regardless of the income level of the contributor or the designated account beneficiary.

Except for amounts rolled over from another ABLE account, contributions to a designated beneficiary's ABLE account in a year are generally limited to the annual federal gift tax exclusion for that year ($18,000 for 2024). However, through 2025, additional amounts can potentially be contributed under a provision of the Tax Cuts and Jobs Act. (See "Additional ABLE Account Contributions Allowed Through 2025," below.) 

For federal gift tax and generation-skipping transfer tax purposes, a contribution to an ABLE account by a person other than the designated account beneficiary is treated as a completed gift to the account beneficiary.

Important: State income tax benefits may be available for ABLE account contributions.

Additional ABLE Account Contributions Allowed Through 2025

A provision in the Tax Cuts and Jobs Act increases the annual limit on ABLE account contributions through 2025. Once the general contribution limit has been reached ($18,000 for 2024), the designated ABLE account beneficiary can himself or herself contribute an additional amount up to the lesser of:

• The applicable federal poverty line for a one-person household for the prior year, or
• The designated beneficiary's compensation for the contribution year.

For the 48 contiguous states and Washington, D.C., the 2023 poverty line for a one-person household is $14,850. It's $18,210 for Alaska and $16,770 for Hawaii.

To qualify to make an additional ABLE account contribution for a particular year, the contributing designated account beneficiary must be an employee or a self-employed individual for whom no contributions were made to a defined contribution qualified retirement plan. These plans include 401(k) or profit-sharing plans, Section 403(b) annuity plans sponsored by a tax-exempt organization or public school, and Section 457(b) deferred compensation plans of a state or local government or tax-exempt organization.

The contributing designated account beneficiary, or a person acting on that person's behalf, must maintain adequate records to ensure that the requirements for the additional contribution privilege are met.

For example, John is a 25-year-old disabled individual who's the designated beneficiary of an ABLE account. He lives in Colorado. In 2024, he's employed at a local grocery store, earning $20,000 in wages for the year. No retirement plan contributions are made on his behalf.

In 2024, John's parents contribute the general maximum of $18,000 to his ABLE account. John's earnings for 2024 exceed the federal poverty line for a one-person household for 2023 ($14,850). So John can make an additional 2024 contribution to his own ABLE account of up $14,850. Additionally, based on his 2024 contributions to the ABLE account, John could potentially claim a saver's credit of up to $1,000 for 2024.

Saver's Credit

Under current tax law, contributions made by the designated ABLE account beneficiary to his or her account through 2025 are potentially eligible for the federal income tax retirement savings contributions credit, also known as the "saver's credit." In general, an ABLE account beneficiary is eligible for the credit if he or she:

• Is age 18 or older,
• Isn't claimed as a dependent on another person's federal income tax return, and
• Isn't a student.

The saver's credit can be up to 50% of the ABLE account contribution, subject to a credit maximum of $1,000.

Tax Treatment of Account Distributions

Distributions from ABLE accounts are federal-income-tax-free to the extent they don't exceed the designated beneficiary's qualified disability expenses for the year. These are any expenses related to the designated account beneficiary's blindness or disability, including:

• Education,
• Housing,
• Transportation,
• Employment training and support,
• Assistive technology and personal support services,
• Health, prevention and wellness services,
• Financial management and administrative services,
• Legal fees,
• Expenses for oversight and monitoring,
• Funeral and burial expenses, and
• Other expenses specified by IRS regulations. 

A portion of distributions in excess of the designated account beneficiary's qualified disability expenses must be included in the account beneficiary's gross income. That amount will also be hit with a 10% penalty tax.

In effect, when distributions for the year exceed qualified disability expenses, the distributions are treated as consisting of the following two components:

1. A pro-rata tax-free return of the principal amount from account contributions, and
2. A pro-rata taxable amount from accumulated account earnings.

The amount included in gross income is based on the ratio of nonqualified distributions for the year to total distributions for the year.

For example, in 2024, Hannah receives a $12,000 distribution from her ABLE account. That amount consists of a return of capital from contributions to the account ($7,000) and accumulated account earnings ($5,000). Hannah uses $9,000 of the distribution to pay qualified disability expenses. In this situation, Hannah's distribution exceeds her qualified disability expenses—only 75% of the distribution is used for qualified expenses ($9,000 divided by $12,000). So, $3,750 of the otherwise taxable amount from account earnings is tax-free (75% of $5,000 of earnings).

Therefore, Hannah owes no federal income tax on $10,750 of the distributions from her ABLE account ($7,000 plus $3,750). The remaining portion of her distribution ($1,250) must be reported as gross income on Hannah's 2024 federal income tax return. She'll also owe $125 for the 10% penalty tax on the taxable portion of the distribution (10% of $1,250).

Account Rollovers

ABLE account distributions can be rolled over free from federal income tax within 60 days to another ABLE account set up for the benefit of the designated beneficiary or an eligible individual who's a member of the designated beneficiary's family. For this purpose, family member means the designated beneficiary's brother, sister, stepbrother or stepsister.

Through 2025, distributions from a Section 529 account can be rolled over federal-income-tax-free into an ABLE account. However, the ABLE account must be owned by the designated beneficiary of the 529 account or certain family members of the designated beneficiary.

Important: The amount that's rolled over counts toward the general annual limitation on ABLE account contributions ($18,000 for 2024). So this rollover option is limited. 

Changes to Account Beneficiaries

An ABLE account's designated beneficiary can be changed federal-income-tax-free, as long as the new beneficiary is an eligible individual who's also a qualified family member of the original designated beneficiary. At the time when the change becomes effective, the successor designated beneficiary must be an eligible individual, as previously defined.

An ABLE program can permit a change in the designated beneficiary of an ABLE account, made during the life of the designated beneficiary, to take effect upon the death of the designated beneficiary. The amount transferred pursuant to such a beneficiary designation is first subject to the payment of any unpaid qualified disability expenses incurred before the original designated beneficiary's death.

Tax Results Upon Death of an Account Beneficiary

Upon the death of the ABLE account's designated beneficiary, the remaining ABLE account balance is first paid out to cover any outstanding qualified disability expenses of the deceased designated beneficiary. Next, any remaining balance is paid to reimburse the state Medicaid plan for medical assistance paid for the designated ABLE account beneficiary after the account was established (net of any premiums paid from the account to a Medicaid buy-in program). But the state must file a claim to receive such reimbursement. Because of this payback provision, it may be advisable to keep only a limited amount of funds in an ABLE account.

Any remaining ABLE account balance is distributed to the estate of the deceased designated ABLE account beneficiary or other beneficiary named to receive ABLE account funds after the death of the designated ABLE account beneficiary. To the extent such post-death distributions consist of ABLE account earnings, they're included in the recipient's gross income for federal income tax purposes, but no penalty tax is owed.

ABLE Accounts Are Gaining Momentum

Municipal advisory firm AKF Consulting Group publishes annual reports on ABLE accounts. The latest report, "ABLE America 2022: Victories and Momentum for Change," found that over 137,000 people with disabilities had ABLE accounts, up roughly 22% from 2021, and ABLE account holders had saved over $1.25 billion as of December 31, 2022.

If you have a loved one with a disability, consider jumping on the ABLE account bandwagon. However, the federal income tax rules for ABLE accounts are complicated. So it's important to meet with your financial advisors to determine what's right for your family's situation.

©  2024