Most people will have heard of the term ‘Testamentary Trust’ before but, as we have observed, very few understand what they are; let alone if they should use one in their estate planning.
The purpose of this post is to give you an understanding about Testamentary Trusts and whether it may be useful for you to include one in your Will.
What is a Testamentary Trust?
A Testamentary Trust is a trust that is set up in a person’s Will; however, the trust itself will only begin once the will-maker has passed away.
It is an option for will-makers to gift part or all of their assets to one or more beneficiary into a trust, rather than outright into their personal names. As you will see in this post, there are various advantages to gifting assets this way.
So, how does it work?
A Testamentary Trust has the following key characteristics:
- Trust property – which includes any assets that the will-maker has gifted to the trust in their Will, as well as any income earned from those assets.
- The trustee – is the legal owner of trust property. A trustee can be one or more people over the age of 18 and even a company in certain circumstances. They are responsible for managing the trust property, making distributions of income and assets to beneficiaries.
- The beneficiary – this is the person or people who will receive the benefit of the trust property. It is entirely up to the will-maker to decide who will be their beneficiaries. Commonly it may be a spouse, children or other close relative or friend.
- Trust deed – the trust deed sets out the terms and conditions that must be followed by the trustee when managing the trust. The trust deed is contained in the will-makers Will.
What are the Advantages of Using a Testamentary Trust in Your Will?
There may be significant tax advantages in taking an inheritance through a Testamentary Trust, particularly where a beneficiary:
- Is a minor;
- Has a high personal marginal tax rate;
- Can claim the tax-free threshold;
- Has a partner on a lower income;
- Has minor children and grandchildren; or
- Has children or grandchildren with no, or lower, taxable income.
Below are 2 simple scenarios showing the possible tax implications of gifts made in a Will.
In the first scenario, the beneficiary (who we will call David Beckham in this example) receives his gift outright. The result is that David is taxed on any future income generated from that gift. While the actual David Beckham may not mind paying an extra $7,000 per year in tax, we are sure the rest of us in the real world would!
In the second scenario, the gift is paid to a Testamentary Trust for the benefit of David Beckham and David’s family, Victoria and their 4 children (according to Wikipedia). Usually the trust will include the beneficiary, their spouse and children.
David would be the trustee of the Testamentary Trust and he would be in control of making distributions of the trust property to the beneficiaries for up to a period of 80 years (this is how long a Testamentary Trust can last for). In most Testamentary Trusts, a trustee will distribute trust property to the beneficiaries in the most tax effective way possible. A trustee would of course consult with their financial advisors in that regard.
The second scenario above is an example of the situation where the income from the trust is distributed to one of David’s minor children, rather than David himself. The result is that no tax would be payable. Why? Because minor children will generally have a tax-free threshold of just over $20,000 provided certain conditions are met.
Another common use for a Testamentary Trust is when a will-maker wishes to ensure that a beneficiary’s inheritance is protected and preserved from:
- Waste and dissipation by the beneficiary;
- Claims on the beneficiary’s assets due to personal or commercial relationship breakdown; or
- Unintended loss by a beneficiary of their government sourced pension or other benefits.
What Are the Disadvantages of a Testamentary Trust?
- Once the Testamentary Trust comes into existence (that is, on the will-maker’s death), the Testamentary Trust needs a tax file number and will need to lodge a tax return each year. There is an ongoing maintenance cost. Most accountants are familiar with this process because the tax return is similar to that of a family trust.
- The will-maker must pay for cost of the Testamentary Trust at the time of creating their Will; however, the benefits of the Testamentary Trust will be enjoyed only once the will-maker has passed away.
Including a Testamentary Trust into a Will may not be relevant to every situation, but they offer valuable advantages in many cases over a simple Will.
Would you like further information?
The information contained on this site is for general guidance only. No person should act or refrain from acting on the basis of such information. You should seek appropriate professional advice based upon your particular circumstances.