When creating a Will, many people choose the simplest option—leaving their assets directly to their children or other beneficiaries. While this approach may seem straightforward, it comes with potential risks, such as financial mismanagement, vulnerability to creditors, or unintended sharing of assets during a divorce.
A testamentary trust in your Will is a simple tool to provide a more flexible and protective way to pass on your assets, ensuring your wishes are honoured and your beneficiaries are supported and protected in a responsible and tax-efficient manner.
What Happens in a Simple Will?
In a simple Will, assets are typically transferred directly to beneficiaries after probate, in their own personal names. However, there are several potential consequences to this:
- Legal Risks: The assets can be vulnerable to claims from creditors or become part of marital property in a divorce settlement. If the beneficiary separates from their spouse after receiving their inheritance, it could result in the inheritance being partially or fully awarded to an ex-spouse. This risk is a significant concern for many parents who want to protect their family legacy and prevent assets from being unintentionally shared outside the family.
- Tax Inefficiencies: If a beneficiary invests their inheritance in their own name, any income from that investment will be taxed at their own income tax rate. This can result in the inheritance generating income that is taxed at a potentially higher marginal tax rate, which may reduce the potential net benefit of the inheritance.
- Unrestricted Access: Beneficiaries receive the full inheritance immediately, regardless of their age, financial habits, or circumstances.
What Is a Testamentary Trust?
A testamentary trust is a type of trust created as part of a Will, activated after the Will-maker’s death. It involves several key roles:
- Testator: The person who creates the Will and specifies the terms of the trust.
- Trustee: Appointed by the testator to manage and distribute the trust’s assets.
- Beneficiaries: Individuals or entities who can receive benefits from the trust.
- Appointor: An individual who has the authority to appoint or remove trustees, ensuring the trust is managed appropriately.
Sometimes, the trustee, beneficiary and appointor can be the same person, such as where a child of the testator is named in those roles.
When the testator dies, the trust jumps into action and the deceased’s assets are transferred to the trust to be held by the trust. The trustee manages the trust (and the assets) on behalf of the beneficiaries, distributing income and capital at their discretion. It is important to remember that the trust does not come into play until the testator dies. While the testator lives, their assets remain in their name and the testamentary trust, laying dormant in the Will, does not change that.
Benefits of Testamentary Discretionary Trusts
- Asset Protection: Assets within a testamentary discretionary trust can be safeguarded from beneficiaries’ creditors, legal actions, or personal circumstances such as divorce or bankruptcy. This is because the assets are held by the trust and not by the beneficiary directly.
- Investment Growth Potential: Capital held in the trust can be used for investment purposes, with any profits—such as rental income from properties or dividends from shares—being distributed to beneficiaries as needed as trust income. This allows the capital to grow and provide ongoing financial support to the beneficiaries for years to come.
- Tax Advantages: Testamentary trusts offer flexibility through trust income distribution, allowing families to minimise tax. Beneficiaries who are not working (such as children) can receive trust income distributions, from the trust, tax free up to the adult tax free threshold ($18,200 at the time of writing this article). For example, if there are 3 young children not yet working included as beneficiaries, the trust can distribute $18,200 to each of them tax free, every year, for the children’s education, living expenses, and extracurricular activities. This can be massive for young families.
- Controlled Distribution: The testator can set specific terms for asset distribution, such as delaying access until beneficiaries reach a certain age or achieve particular milestones.
- Support for Vulnerable Beneficiaries: Provides a structured financial arrangement for beneficiaries who may be minors, have disabilities, or lack financial management skills.
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HOW TO CREATE a Testamentary DIscretionary Trust
- Drafting the Will: Clearly outline the terms of the trust, including the appointment of trustees, identification of beneficiaries, and specific instructions.
- Selecting Trustees: Choose trustworthy individuals or professional entities capable of managing the trust responsibly.
- Defining Beneficiaries and Terms: Specify who will benefit from the trust and under what conditions.
- Legal Compliance: Ensure the trust complies with Australian laws, including tax regulations and the rule against perpetuities.
Case Studies: Practical Scenarios for Testamentary DISCRETIONARY Trusts
1. Young Children (under 18) and Surviving Spouse
Scenario: A couple has three children under the age of 18. The couple agree that the children should recieve the benefits of the estate, once they both die. However, one of them dies before the children are 18, and they have directed that the surviving spouse recieves the whole estate.
What If a Simple Will Is Used? Using a simple Will in this situation may result in the entire estate being transferred outright to the surviving spouse directly. If the surviving spouse later re-partners and experiences a family law separation, the assets inherited by them directly could become part of the matrimonial pool and be subject to division, which may further deplete the inheritance which should have been for the children.
Solution: A testamentary trust ensures that the children’s inheritance is managed responsibly. Instead of going to the surviving spouse, the inheritance can go to the trust (which the surviving spouse controls). This means that the surviving spouse has access to funds for the children’s education, living expenses, and extracurricular activities while ensuring that the capital remains protected until the time comes where the surviving spouse wishes to hand control of the trust to the children (when they are adults, or when the surviving spouse dies). In addition, while the children are children and not working, distributions can be made to each of them from the trust tax-free up to the adult tax-free threshold, which is currently AUD 18,200 (subject to change based on annual tax adjustments).
Outcome: The surviving spouse has financial flexibility without the risk of prematurely depleting the inheritance. The trust also protects the inheritance from any potential risks such as creditors, or divorce of the surviving spouse in the future.
2. Adult Children with Marital Concerns
Scenario: A testator has two adult children, both married, but there are concerns about potential relationship breakdowns. The testator wishes to gift everything to the children on their death, and has no other spouse or dependants.
What If a Simple Will Is Used? In a simple Will, the inheritance is gifted to the children directly in their personal names. These inherited assets are now included in any potential property separation with their spouse. This could lead to significant portions of the inheritance being awarded to an estranged spouse in the event of a divorce, undermining the testator’s intention to keep wealth within the family.
Solution: By using a testamentary trust, the testator can ensure that the inheritance remains protected from being included in any divorce settlement. The trustee manages the distribution to the children, shielding the assets from becoming joint marital property.
Outcome: The children can use their inheritance for personal needs without the risk of losing assets in a marital dispute.
3. Grandchildren and Multi-Generational Wealth Planning
Scenario: The testator’s children are adults with their own children (grandchildren of the testator). The testator wants to ensure the grandchildren also benefit.
What If a Simple Will Is Used? A simple Will might overlook specific provisions for grandchildren, leading to the risk that funds intended for future generations could be depleted by immediate beneficiaries. Additionally, any income derived from the inheritance (once it is recieved by the adult beneficiaries in their own names) will be taxed on their personal income rate (commonly between 32.5% and 37%.. or more!) and can not be distributed to the grandchildren tax free. Finally, as mentioned above, these inherited assets will also be included in any potential property separation with their spouse. This could lead to significant portions of the inheritance being awarded to an estranged spouse in the event of a divorce, undermining the testator’s intention to keep wealth within the family.
Solution: A testamentary trust can allow distributions and gifts to grandchildren while still allowing the primary beneficiaries (the children) to access funds. Additionally, the trust provides significant tax advantages by allowing distributions to grandchildren that may be taxed at lower marginal rates, leveraging the adult tax-free threshold for each grandchild. Furthermore, the trust can be structured as an intergenerational trust, allowing for the control to be handed down, when appropriate, to the grandchildren, thereby ensuring wealth preservation and legacy protection across multiple generations.
Outcome: A testamentary trust structure supports intergenerational wealth transfer, ensuring the grandchildren benefit without diluting the primary inheritance.
Considerations and Potential Drawbacks
- Complexity: Testamentary trusts can be complex to establish and administer after the testator has died.
- Costs: There are some costs associated with setting up the trust, as well as ongoing administrative expenses. These are incurred after the testator has died and would be paid by the estate.
- Trustee Selection: Choosing an inappropriate trustee can lead to mismanagement.
- Requirement to Be Included in the Will: Testamentary trusts must be explicitly included in the Will at the time it is drafted. If they are not, the potential tax benefits, asset protection, and distribution control cannot be utilised.
Recent Trends and Considerations
With the anticipated surge in wealth transfers from older generations to the younger generations, many Australians are considering testamentary trusts to manage inheritances effectively. These trusts provide tax benefits, asset protection, and controlled distribution. While testamentary trusts appear to be more complex than ‘simple Wills’, they can provide massive value to families in terms of financial support and asset protection.
Conclusion
Testamentary trusts are a valuable estate planning tool in Australia, offering tax benefits, asset protection, and controlled distribution of assets to beneficiaries. However, they require careful planning and professional legal advice to ensure they meet your specific needs and comply with legal requirements.
If you would like to make a free appointment to discuss testamentary trusts, please feel free to contact Jacaranda Law to make an appointment.
The information provided in the document is a general summary and is not intended to be nor should it be relied upon as a substitute for legal or other professional advice. You should make an appointment with Jacaranda Law to receive appropriate tailored advice for your specific situation.
