What is a Testamentary Trust?
A testamentary trust is simply a trust established by a will. Testamentary trusts come in many forms, ranging from simple to complex. The terms of the trust are contained in the will and the trust is only established when the will comes into effect on your death. Whether a testamentary trust is of benefit (and, if so, what form of testamentary trust should be used) will depend on your circumstances.
What are the advantages and disadvantages of Testamentary Trusts?
Testamentary trusts have a number of potential benefits. These advantages include:
- Flexibility and the ability to deal with changing circumstances of beneficiaries over time.
- Some degree of asset protection may exist in the event of beneficiaries being divorced or bankrupt.
- Potential tax benefits by way of income splitting and particularly for children or grandchildren under 18 years of age.
- Possible deferral or avoidance of capital gains tax liabilities.
However, testamentary trusts may not be suitable for everyone. Some possible disadvantages are:
- There is no actual benefit for you, the will maker, although there may be benefits for your beneficiaries.
- Cost – testamentary trusts are often more complex, they generally cost more to produce and they generally involve ongoing accountancy and other fees during their operation.
- Complexity – testamentary trusts are harder to explain, harder to understand and they have more complex administration requirements than a traditional will.
- There can be no assurance that the benefits of a testamentary trust will continue to exist into the future. This is particularly important in relation to the potential tax benefits.
Why would you want a Testamentary Trust?
- Establishing a testamentary trust can provide your beneficiaries with flexibility in dealing with their inheritance. Whether an actual benefit accrues to a particular beneficiary depends on their circumstances and needs at the time of your death, but a testamentary trust may give options to cover a number of situations.
- Tax benefits
If you have significant assets and your beneficiaries are looking for a more tax effective form of inheritance, then a testamentary trust may help. A trustee of a testamentary trust has discretion to determine which of the potential beneficiaries receive the income/capital of the trust. As tax is paid on the income of the trust at the marginal rate of the beneficiary who received it, there is potential for tax savings. Children under 18 who receive income from a testamentary trust get the benefit of the tax threshold together with the stepped marginal tax rate system for income above the tax threshold. If you have children or grandchildren under 18 years of age, significant tax savings are possible.
- Concerns about a beneficiary
If you have concerns about whether one or more of your beneficiaries can properly manage a large inheritance (possibly due to drug or gambling problems or just a general lack of common sense) a testamentary trust allows you to appoint another person as executor/trustee so that income and assets can be passed to the beneficiary on a needs basis.
- Beneficiaries’ inheritance may be protected from Family Law claims
If you have concerns about the spouse or de facto of one of your children, a testamentary trust may assist. For example, a traditional will might leave an inheritance directly to your daughter. After a divorce, your son-in-law may have significant rights to claim a share of your daughter’s inheritance. A form of testamentary trust may assist to minimise this risk.
- Beneficiaries’ inheritance may be protected from bankruptcy
If you have a child who is engaged in business and possibly exposed to liability claims, they may get some liability protection if you use a testamentary trust will.
- Capital gains tax
A testamentary trust gives scope for capital gains tax savings, for example by having the flexibility to pass assets which are liable for capital gains tax to a beneficiary on a low income. This can sometimes reduce or remove the capital gains tax liability. Also, an asset passing into a testamentary trust does not trigger a capital gains tax liability, therefore allowing beneficiaries to defer that tax liability.
What does a Testamentary Trust “look like”?
Testamentary trusts range from reasonably simple wills to extremely complex and lengthy documents. Generally, a will that establishes a testamentary trust will be more complex than a simple “I give everything to my spouse” will.
The general principle is that instead of leaving an inheritance directly to a nominated beneficiary, you leave the inheritance to the trustees of a discretionary trust (with wide discretionary powers and a range of potential beneficiaries including your “nominated” beneficiaries).
Like a traditional will, a testamentary trust only comes into existence after you have died. Until then, your will has no effect and you can change it at any time.
In contrast to a testamentary trust, a traditional will gives beneficiaries no choice but to take their inheritance in their own name – in some circumstances resulting in tax consequences and liability/protection problems.
So why wouldn’t you have a Testamentary Trust?
Some people like to avoid complexity. Some people want to avoid what they perceive as unnecessary cost. For some people (depending on their assets and family circumstances), a testamentary trust provides no real benefit over a traditional, simple will.
Testamentary trusts can come in different forms, and control of the trust (through the selection of the trustee and appointor roles) is a crucial aspect of how a trust functions and what level of protection it offers.
On balance however, a properly prepared testamentary trust generally provides flexibility and levels of protection for beneficiaries beyond those available from a ‘simple’ or traditional form of will.