Family trusts vs Testamentary trusts
You may have heard the term testamentary trusts and wondered what they are and how they can help you in estate planning.
Similar to a family trust, a testamentary trust is a discretionary trust. The key difference is that testamentary trusts are created in your will and come into effect after you die, whereas a family trust is created during your lifetime.
People use testamentary trusts for a variety of reasons ranging from control and protection of vulnerable beneficiaries to effective tax planning.
As estates have increased in size and family structures have become more complex e.g ‘blended’ families, creating trusts in wills has become more commonplace.
Is there a minimum estate size for testamentary trusts to be worthwhile?
There are two costs to testamentary trusts – the set up cost and the on-going cost. As wills incorporating testamentary trusts are more complex to draft, they usually cost more than a standard will. Complexity increases the more you try and achieve in your will as your lawyer needs to consider how to draft your will to ensure that your wishes are incorporated correctly into your will. This is what I refer to as the “If – but – maybe”.
If this happens, then do that.
But, if that happens, then do that.
Maybe that might happen, so we need to consider that.
After you die, the testamentary trust is ‘activated’ and there are running costs associated with it. If a professional trustee is involved, there will be a fee charged to manage the trust. Other administrative costs include accountancy fees and investment management fees.
It is important to work out whether the benefits of a testamentary trust outweigh the associated costs.
Testamentary trusts are great vehicles but they are not suitable for all situations.
Minimising tax
Much like family trusts, testamentary trusts allow your beneficiaries the ability to income split and minimise tax. As a discretionary trust, the trustee has the discretion to direct any income earned in the most tax effective way i.e. to the beneficiaries with the lowest tax rates.
The key advantage that testamentary trusts have is that minor beneficiaries (children) are taxed at adult rates. This is different to a family trust established during your lifetime. In a family trust, minors are taxed at penalty rates.
Example:
Your son Bob has two children under the age of 18. Both Bob and his wife Sally are professionals who earn good incomes and are therefore on high marginal tax rates.
If your estate is left to Bob in a testamentary trust, the income could be distributed to his two children instead of to Bob directly.
If we assume that the trust earned income of $50,000, the income could be distributed as follows:
If the $50,000 is taxed in Bob’s hands, he would have had to pay $21,000 in tax instead of $2,660 in the above scenario.
Protecting the inheritance
Protecting beneficiaries is another key reason that testamentary trusts are used. Sometimes it is protection from themselves and sometimes it is protection from others.
You may not trust one or more of your beneficiaries to act in their own best interests. This could be due to disability, incapacity or inability to manage financial affairs. A trustee could be appointed to manage their inheritance for them.
It could also be protection from creditors, or protection from a divorce settlement. Using a testamentary trust may minimise the risk of the inheritance being lost if structured appropriately.
These are often quite complex issues which require proper consideration and advice.
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