A popular tool used in estate planning is testamentary trusts. A testamentary trust is a trust which is established within your will and comes into effect upon your death. Unless you choose for there to be restrictions, testamentary trusts can be made to be very flexible, giving your chosen trustees full control. The trustees may therefore choose the trust's investments and who to distribute the trust's income. They can also withdraw and distribute some or all of the assets of the trust if they choose.
The use of testamentary trusts can help protect assets and minimise tax for the family as a whole.
The most significant tax benefit of testamentary trusts is the ability for the trustees to choose which family members receive distributions of income each year. Importantly, child beneficiaries who receive distributions are taxed at adult rates. This means that each child beneficiary also receives the tax free threshold which is currently over $18,000.
Where an intended beneficiary is facing bankruptcy or works in a high risk industry/runs their own business, it can be dangerous leaving your estate directly to the beneficiary. Where your estate is passed to a testamentary trust, the assets are not the property of the beneficiary and as such they are better protected from creditors and predators.
Mr White is 65 years old and has two adult children, Jenny and Richard. Mr White's wealth, including his home is approximately $2 million.
Jenny is a doctor and she runs her own practice. She earns income of $200,000 per year. Her husband is also a high income earner and they have two children aged four and two.
Richard is single and likes to travel, working from time to time. He generally earns a low income and does not intend to settle down any time soon.
Mr White initially planned for his will to leave half of his assets to Jenny and half to Richard ($1 million each). He would like some of that wealth to be passed on to the grandchildren at some point however he will leave that to the discretion of the parents.
In Jenny's case, her family may be considerably better off if Mr White leaves their share in a testamentary trust rather than to Jenny directly. Jenny will be the trustee of the trust and will therefore still have full control of the assets.
Assume that the $1 million inheritance when invested earns a modest income of 3.5% ($35,000). If taxed to Jenny at a marginal rate of 47% including Medicare Levy, Jenny will pay tax of $16,450 on that income.
If instead a testamentary trust is used, Jenny may decide to distribute the $35,000 income equally between her children ($17,500 each). In this instance no tax would be payable. The net benefit to the family in that year alone is therefore $16,450.
As Jenny is in a high risk profession, her family is also more comfortable knowing that the estate assets are well protected in the event that a claim is ever made against her.
In Richard's case, a testamentary trust may only have limited value in his current situation. Mr White may decide that Richard's share is to be received by him directly. Alternatively, the will may provide that a testamentary trust will form unless Richard elects at that point to receive the inheritance directly instead. This may be the preferred option because Richard's circumstances may easily change in future.
It is important to note that in this example, Jenny and Richard still have separate control of their respective inheritances, even when testamentary trusts are used.
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