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Why testamentary trusts are not only for the wealthy

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As estate lawyers, we often have clients come in to make a Will and they have not heard of testamentary trusts. Or if they have heard of them, they assume they are overly complicated or just for those that have significant wealth. 

When you take into account the value of your family home and any superannuation and life insurance you have, it is not uncommon for the average family to have substantial sums being transferred down to the next generation. A testamentary trust gives your children the maximum flexibility and protection following your death so it is worth discussing with a professional to determine whether it is something that may suit your needs. 

In this article, we look at what a testamentary trust is, some of the advantages of this type of trust and when it might be suitable for you and your beneficiaries. 

What is a testamentary trust?

It is a discretionary trust that is set up by a Will. In a standard Will without testamentary trusts, your beneficiary receives their inheritance directly and then decides how the money is invested or spent. The beneficiary pays income tax at their marginal tax rate on any investment income they earn from the inheritance. Plus if they have a relationship breakdown or insolvency, their inheritance is part of their pool of personal assets. 

By contrast, a testamentary trust involves a trustee holding the inheritance on trust for a number of potential beneficiaries identified in the Will. The trustee then has the discretion to regularly distribute the income and capital of the trust between the potential beneficiaries.

What are the advantages of a testamentary trust?

There are a number of benefits a testamentary trust can provide including protection from relationship breakdown and bankruptcy, as well as tax planning opportunities. 

By having a testamentary trust set up for your beneficiary (say, your child), their inheritance can be protected from divorce as the trust keeps your child’s inheritance separate from their own assets. If you are particularly concerned about a relationship breakdown, we can customise a testamentary trust to provide the maximum protection for your beneficiaries.

A properly designed testamentary trust can provide important protection for your intended beneficiaries. The assets within the testamentary trust are segregated from the beneficiarie’s personal assets and will be protected if they get into financial difficulties or become bankrupt.

Additionally, a testamentary trust provides considerable opportunities to minimise the tax that would otherwise be payable by your principal beneficiaries. The trust enables the trustee to distribute income between beneficiaries in such a way as to manage the total income tax payable by the group. This is particularly beneficial if minors are beneficiaries, because when minor children receive income from a testamentary trust, they are taxed on that income as adults and enjoy an adult’s tax-free threshold.

Should you consider a testamentary trust?

Determining whether a testamentary trust within your Will is something worth considering is usually based more on the circumstances of the intended beneficiary rather than the will-maker themselves. We cover off some of the major considerations for when this type of trust might be suitable. 

When significant wealth is being passed on

If a considerable amount of money is going to be inherited, this makes the sophistication of a testamentary trust worthwhile in terms of wanting to protect the assets that are inherited and in terms of the tax benefits. 

If a beneficiary relationship is at risk of breaking down

A testamentary trust should also be considered if you are concerned about any of your children or intended beneficiaries going through a relationship breakdown. Even if there is no current risk and a relationship looks stable right now, statistics tell us that relationships do break down fairly often. 

So considering asset protection for your children is worthwhile, particularly from a business point of view. For example, if you are running a business and want to protect assets from being held in your personal name. When your children have their own children a testamentary trust provides opportunities to share income within the family group and get the tax benefits.  

If you want to have some control around how the inheritance is spent 

You might want to put some controls or checks and balances in place around the ongoing use of your inheritance.  So for example, the terms of the testamentary trust might ensure your children do not just spend all the money in one go. With a trust, you can put some restrictions or time frames around the use of inheritance. 

Providing flexibility for your beneficiaries

Upon your death, the trust will be set up so there is nothing that needs to be administered before then. All that needs to happen is that you have your lawyer include the relevant terms in your Will.  Most clients include a testamentary trust in their Will to give children extra flexibility. Rather than putting restrictions in place, it is about giving extra options. 

The variables when it comes to testamentary trusts

Is the trust mandatory or optional? 

There are a number of variables that can be adjusted in terms of having testamentary trusts in your Will. One of the important things to note is that your lawyer can make the testamentary trusts optional for the beneficiary. Provided that you are happy to do so, your child could choose not to use a testamentary trust after getting tax, financial and legal advice and instead take the inheritance into their own hands following your death. But for your children to have that option, the terms must be included in the Will. It cannot be set up after your death.

Age can often be a consideration here. For most of our clients, they want their children to reach a particular age, such as 25, to then be happy for their children to choose to opt-out of the testamentary trust. But there might be circumstances in which parents require their children to use the testamentary trust and prefer to have the funds drip fed over time to the beneficiary. 

Does each beneficiary have their own trust?

One of the variables that can be provided for includes whether each intended beneficiary has their own separate testamentary trust, or whether there is one trust for all the intended beneficiaries. Most people prefer each beneficiary to have their own separate testamentary trust so that the beneficiaries are not financially tied to each other. 

Who is the trustee?

Another variable is who the trustee is of each testamentary trust. In most cases, a parent would want their child as the trustee of their own testamentary trust so that the intended beneficiary is in control of the inheritance. But occasionally parents may want to appoint a co-trustee with their child or may wish to appoint other trusted people as trustees of that testamentary trust. This will depend on your objectives and the level of asset protection you are looking to achieve.

One thing that is popular for our clients is for younger children is to have a staged passing of control.  So, for example, to allow the child to become a co-trustee with another trusted family member say at the age of 21. Then once they reach 25 they have the option to then take over or control the trust. 

This allows for a gradual increase in responsibility to ensure the child has continuous and ongoing support and accountability. So it might be an option to have a co-trustee if, for example, you think your child needs a bit of extra help with financial management or there are strong reasons why that child should have asset protection. The best approach for you will depend on your objectives and the particular circumstances and dynamics of your family.

Who are the beneficiaries?

The potential beneficiaries of the testamentary trust is another variable to consider. Your Will sets out who may receive distributions from the trust, but being named as a potential beneficiary does not give the potential beneficiary a fixed entitlement. Instead, it just creates a list of people to whom a trustee may choose to distribute income and capital from the trust. This could either be a broad range of family members and related entities or the will-maker might choose to limit it only to their direct descendants. 

As experienced estate planning lawyers, we can discuss your wishes and guide you through your options to create a Will with testamentary trusts that suit your circumstances. Your beneficiaries can only enjoy the advantages of a testamentary trust if you provide for this in your Will because a testamentary trust cannot be inserted into a Will after your passing.

The DDCS wills and estate planning team are highly experienced and specialise in helping people navigate issues like these. To discuss your circumstances, phone our team on (02) 62127600 or fill in the contact us form and our team will be in touch.