What is a testamentary trust will?

We recently explained why all business owners need a will, and the consequences of not having one. We also touched, but didn’t elaborate, on the concept of estate planning. This involves (among other things):

  • putting in place mechanisms that protect your legacy;
  • utilising tax effective strategies that benefit your survivors;
  • factoring in any superannuation benefits and life insurance policies that come into play; and
  • making provision for the management of your affairs if you were to lose decision-making capacity.

A testamentary trust will is a key component of an effective estate plan. I will explain why in more detail shortly. In writing this article, I am assuming that you are somewhat familiar with trusts and the terminology relating to trusts. If you would like a quick refresher, check our earlier article (“what is a trust?”) before reading on.

Testamentary trust wills

The basics

A testamentary trust will creates a discretionary trust in your will. This is contrasted with the creation of a trust while you are alive using a trust deed. When you make a gift under a testamentary trust will, that gift is held on trust for your beneficiaries. What this means in practice is that:

  • the trust does not exist until you die (i.e. it will be of no benefit, while you are alive); and
  • your will specifies the terms governing the control and administration of the trust, including:
    • the trustees of the trust;
    • the powers to appoint and remove trustees; and
    • the application and use of funds held on trust.

Example

To demonstrate what we mean, this is what will happen when I die:

  • A testamentary discretionary trust will be created for my wife, called the Sami Sara Testamentary Discretionary Trust.
  • My wife will be the trustee of that trust.
  • She will also be a beneficiary of that trust, along with my children and extended family members.
  • My wife will assume control of my estate. She will hold those funds as trustee of the Sami Sara Testamentary Discretionary Trust. As trustee, my wife can invest that money as she deems fit. She will also be entitled to distribute the proceeds among all the beneficiaries, and that decision can also be made her discretion.

Why is a testamentary trust so valuable?

What makes a testamentary trust so valuable if it is just a form of discretionary trust? Here are a few reasons:

Protecting assets for underage children

A testamentary trust allows your estate to be retained in trust until your underage children reach a certain age of your choosing (called the ‘preservation age’). Once those children reach the preservation age, only then will they gain control of the trust and their inheritance. If the preservation age is a relatively older age (e.g. mid to late 20s), your children cannot waste their inheritance during their early adulthood.

Importantly, your children would still be entitled to receive income from the trust from the time that it comes into existence at the discretion of the trustee that you appoint. This is usually applied for their welfare (e.g. to pay school fees, university expenses and the like).

Asset protection

If your estate passes to a trust, those owed money by your beneficiaries cannot benefit from your gift. This protects a person’s inheritance from certain risks. The following example demonstrates how this would work:

Jim was a property developer. Whilst he was quite successful, one of his projects went awry forcing him to become bankrupt. Unfortunately, at about the same time, Jim’s last surviving parent also died, leaving him a gift of $500,000.

As the parent’s will did not involve a testamentary trust, the executor of the estate could only gift that $500,000 to Jim. Given that Jim was bankrupt at the time, Jim’s trustee in bankruptcy received the majority of the gift.

Had a testamentary trust been utilised in the above example, the executor of the estate would have had the discretion to retain and invest the gift, or apply it to one or more beneficiaries while Jim was bankrupt.

Tax benefits

The trustee of a testamentary trust can invest your estate in income producing investments. The trustee can also distribute the income earned among several beneficiaries, taking advantage of:

  • the tax-free threshold of approximately $18,000 applicable to each beneficiary; and
  • the lower tax brackets which apply to some beneficiaries.

There is also a fundamental difference between an ‘ordinary’ discretionary trusts (established by trust deed while you are alive) and testamentary trusts, and this difference has significant tax consequence. Ordinarily, the highest marginal tax rate will apply to most funds distributed from a trust to underage children. This is because those funds are ‘unearned income’ for tax purposes. This rule does not apply when it comes to testamentary trusts, meaning that the usual tax-free thresholds and income brackets will apply.

To demonstrate the significance of the above, if you were to die and leave behind a spouse and two children:

  • your estate can be invested in income-producing investments;
  • the trustee can distribute approx. $54,000 of that income to your beneficiaries tax-free ($18,000 to each of your spouse and two children); and
  • income which exceeds that amount can also be distributed three ways, to take advantage of the lower tax brackets.

What are the drawbacks of a testamentary trust will?

There are two obvious drawbacks which arise from what we have just described: complexity and cost.

A testamentary trust will is by its very nature a complex document, as it must deal with both the administration of your estate upon your death and specify the terms of your trust. Therefore, while a simple will is ordinarily 5-6 pages at most, a testamentary trust will is likely to be about 20-30 pages in length.

That level of complexity also applies after you die, as your survivors will need to call on the assistance of accountants and financial advisors to fully take advantage of benefits that the testamentary trust allows for. That in turn adds ongoing costs to the administration of your affairs.

Notwithstanding the above, in our view the asset protection benefits and potential tax savings far outweigh these costs.

Next steps

Get in touch if you would like more information about testamentary trust wills, or to make an appointment to discuss your estate planning requirements.