Are you concerned that:
Your beneficiaries may not have the ability to manage or protect the wealth you have accumulated after you die – for example, they might have lost legal capacity or they might have substance abuse/gambling issues or they might be spendthrifts
Your beneficiaries could face bankruptcy, divorce or legal action
Your beneficiaries might not receive the full benefit of the income generated by your assets because they are high income earners and therefore that income will be heavily taxed.
If you answered yes to any of these questions, it might be prudent for you to consider using a testamentary trust, rather than distributing assets to your beneficiaries via your will.
What is a testamentary trust?
A testamentary trust is incorporated in a will, and doesn’t come into force until the death of the will maker. The will maker decides which assets are held in the trust and who will receive them. A testamentary trust may provide tax advantages for the beneficiaries as well as asset protection benefits.
Once a testamentary trust comes into force, the assets can be transferred directly to the trustee of the testamentary trust. The trustee (or trustees) then has effective control of the trust and its assets, though the trustee must act within the rules of the trust deed (which were designed by the will maker) and in accordance with their fiduciary obligations and state trustee legislation.
The trust’s nominated beneficiaries are generally the will maker’s spouse, children and/or grandchildren.
The trustee generally has discretion to decide which of the nominated beneficiaries receive income and capital distributions each financial year.
It is therefore important you appoint someone you trust to act as trustee (for example your spouse or adult children), or use the services of a fiduciary company.
How does a testamentary trust protect assets?
The testamentary trust legally owns the assets you place in it. Your beneficiaries do not.
Therefore, those assets may be protected from your beneficiaries’ creditors in the event of their bankruptcy or successful legal action against them.
Similarly, holding assets in a testamentary trust may provide significant protection in a potential divorce property settlement.
Your beneficiaries will not have access to your assets in the trust to liquidate and spend as they see fit. This can help ensure your assets are protected from beneficiaries who might misuse their inheritance because they are poor money managers.
In so doing, you may be able to improve the preservation of your assets for the next generation. However it is imperative the testamentary trust be drafted appropriately to ensure it is successful in protecting your assets.
How can a testamentary trust be tax effective?
Depending on the circumstances of your beneficiaries, a testamentary trust could assist them with income splitting for tax purposes i.e. distributing income from the trust to beneficiaries who earn little or no other income. This means the income will be taxed less harshly than if it was distributed to a beneficiary who is on a high marginal tax rate.
Importantly, any income allocated to a child under 18 from a testamentary trust is subject to adult tax rates (including the $18,200 tax free threshold). Note: other types of unearned income which is distributed to children is generally taxed at penal rates.
Here’s an example to explain the potential tax effectiveness of distributions from testamentary trusts.
In our indicative example, Eve dies leaving behind two sons and three grandchildren. Eve has set aside $1 million dollars for each son. Both sons are on the highest marginal tax rate of 45% (plus levies).
If Eve distributes this money via her will and the sons invest this to generate an income of say 4% p.a., almost half of that income will be lost to tax (see Chart 1).
If, however, Eve utilises a testamentary trust, the amount of tax paid could be significantly reduced. For example, the trustee could choose, depending on the terms of the trust deed, to distribute no income to the two sons, but instead distribute the income to their spouses and children who earn no other income (see Chart 2).
As a result, the families would pay no tax on the income distributed by the testamentary trust. And, should one of the sons face bankruptcy, divorce or legal proceedings, Eve’s assets will be protected.
Gifting via a will versus using a Testamentary trust – taxation comparison
*This is an indicative example. Each individual’s circumstances may differ and impact any tax liability. You should obtain your own tax advice.
Disclaimer: This article is not legal advice and should not be relied on as such. Any advice in this document is general advice only and does not take into account the objectives, financial situation or needs of any particular person. You should obtain financial advice relevant to your circumstances before making investment decisions. Where a particular financial product is mentioned you should consider the Product Disclosure Statement before making any decisions in relation to the product. Whilst every care has been taken in the preparation of this information, Australian Unity Personal Financial Services Ltd does not guarantee the accuracy or completeness of the information. Australian Unity Personal Financial Services Ltd does not guarantee any particular outcome or future performance. Australian Unity Personal Financial Services Ltd is a registered tax (financial) adviser. Any views expressed are those of the author and do not represent the views of Australian Unity Personal Financial Services Ltd. If you intend to rely on any tax advice in this document you should seek advice from a tax professional. Australian Unity Personal Financial Services Ltd ABN 26 098 725 145, AFSL & Australian Credit Licence No. 234459, 114 Albert Road, South Melbourne, VIC 3205. This document produced in January 2016. © Copyright 2016