Testamentary trusts
Testamentary trusts are becoming increasingly common, and for good reason.
Anyone who is considering a testamentary trust needs to understand three important issues:- What is a testamentary trust?
- How does a testamentary trust work?
- Why is a testamentary trust important?
What is a testamentary trust?
A testamentary trust is a trust established by a Will.
The advantages of setting up optional, discretionary testamentary trusts in a modern Will are the taxation and asset protection benefits. By comparison, a typical Will that does not include testamentary trusts, offers little assistance to a beneficiary of an inheritance in relation to tax efficiency and asset protection.
A testamentary trust can continue for up to 80 years from a person’s death, so it can benefit several generations of family members.
How does a testamentary trust work?
In a typical Will, with no testamentary trusts, each beneficiary is left their inheritance outright. But in a will that contains testamentary trusts, each beneficiary is left their inheritance as trustee of a trust with wide discretionary powers.
Each beneficiary can retain complete control of their inheritance. Alternatively, in appropriate circumstances, a special protected testamentary trusts can be created to protect the interests of a beneficiary who is vulnerable because, for example, of a physical or mental disability, an issue with creditors, or a marriage breakdown.
Why is a testamentary trust important?
A testamentary trust is important because of the benefits that may flow from it to a beneficiary. These include:
- Income and capital gains tax savings - a beneficiary may be able to reduce personal income tax by splitting income from the investment of the inheritance between a range of family members, including children, at low tax rates. And a beneficiary may also be able to minimise Capital Gains Tax which can arise from the sale of a person’s assets after their death.
Consider this example:
John receives a $500,000 inheritance. John invests his inheritance and earns $50,000 interest annually. As John’s personal income attracts the highest marginal tax rate, John pays additional income tax of $24,000 out of the interest earned by his invested inheritance. If John had received his inheritance through a testamentary trust, he would have been able to split the income equally between his non-working wife and children who could have each paid no tax at all, representing a tax saving of $24,000 to John.
- Beneficiary’s inheritance protected from creditors - Assets that pass to a testamentary trust from an estate are owned by the trust. The assets are not owned personally by the beneficiary and they do not form part of the beneficiary’s personal estate. So a creditor cannot take the assets held in the trust.
Consider these examples:
Jack owned his own business which, during an economic downturn, was placed in liquidation. As a result, Jack was made bankrupt. A year earlier, Jack received an inheritance of $500,000.00 from his mother. As Jack received his inheritance in his own name, it was able to be taken and used to pay creditors of Jack’s business. If Jack’s mother had included a testamentary trust in her Will, Jack’s inheritance may not have been available to creditors of his business.
Sally owned and ran a successful hairdressing saloon. She had deliberately ensured that most of her assets were in her husband’s name, so that if her business went bad, their home and savings would be protected. When Sally’s mother died, she inherited her mother’s house – unfortunately in her name. Though the business was doing well, its future success was not guaranteed. To protect her inheritance from the risk of a future possible failure of her business, she transferred it to a trust and paid $23,000.00 in stamp duty. This expense could have been avoided if Sally’s mother had included a testamentary trust in her Will.
- Beneficiary’s inheritance protected from family law claims - a testamentary trust may also provide some protection for a beneficiary who is experiencing matrimonial difficulties. By providing for a beneficiary’s entitlement to be held in a testamentary trust, the beneficiary can isolate their inheritance from their personal assets. This may protect their inheritance from family law property proceedings.
For example:
When Mary died she left her only son Jack an inheritance of $500,000.00. Jack had been married to Jill for 10 years at the time but they separated shortly after. Jack and Jill’s matrimonial property amount to $300,000.00 after the mortgage was taken into account. In determining the property settlement, the Court took into account Jack’s inheritance, but because of the terms of the testamentary trust that held those funds, the court did not include those funds in what was available for distribution to Jill. Thus the only property available to be distributed was $300,000.00, and although Jill did get more than half of that sum it was below what she might have received had Jack’s inheritance been held by him in his own name rather than in a testamentary trust.
A word of caution
A testamentary trust within a Will gives beneficiaries more flexibility, and options not available in typical Wills. These options will achieve significant benefits to beneficiarie. But there is no “one size fits all” testamentary trust. It is important that any Will which incorporates testamentary trusts be prepared by a lawyer experienced and skilled in tailoring a document of this nature to the specific needs and circumstances of the individual for whom it is prepared.A Stacks Wealth Protection Specialist will be able to assist you to set up a testamentary trust that best meets your particular circumstances.
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