Testamentary trusts safeguarding wealth

A testamentary trust is a trust created by your will. It comes into effect after you pass away. Simply put, it’s a legal structure written into your will that directs some or all of your estate into a trust, rather than directly to individuals.

A trustee, appointed by you in your will, manages those assets on behalf of your chosen beneficiaries, such as your spouse, children, or other family members.

It is different from a standard family trust. A testamentary trust is established upon death according to your will’s instructions. The trust can hold assets like cash, investments, real estate, or shares, and it can last for many years, benefiting not just your immediate heirs but potentially future generations.

The key here is that assets in a testamentary trust are not given outright to beneficiaries at your death. Instead, they are held and managed within the trust structure. This arrangement can offer greater protection and flexibility in how your wealth is used and distributed over time.

The primary advantage of a testamentary trust is asset protection. By placing inheritance into a trust, there is an added layer of protection around assets. Here are a few examples of why it works.

Divorce: If your beneficiary, say, your adult child, goes through a divorce, assets they inherit outright could be considered part of the marital property pool. This means some of your hard-earned wealth might end up with an ex-partner. The trust generally owns assets held in a testamentary trust. This can make it harder for those assets to be split in a divorce settlement. In effect, a testamentary trust helps keep family money in the family. For example, if you leave $500,000 in a testamentary trust for your daughter and she later divorces, that $500,000 could remain in the trust for her benefit rather than being up for grabs in the divorce proceedings.

Protection from creditors and bankruptcy: Similarly, if a beneficiary encounters financial trouble, such as bankruptcy or creditor claims, assets in the testamentary trust are generally safeguarded. Since the beneficiary doesn’t personally own the trust assets, creditors typically cannot seize those assets to satisfy personal debts. Let’s say your son is a business owner who faces an unexpected lawsuit or bankruptcy. The inheritance you left him in a testamentary trust would be much more difficult for creditors to reach than money left to him directly in a simple will.

Guarding against poor financial decisions: Not all risks come from outside. Young or vulnerable beneficiaries might sometimes squander a lump-sum inheritance due to a lack of financial experience or poor influences. A testamentary trust allows the trustee to manage and distribute funds responsibly. You can set rules or guidance in your will for how the trust should support your beneficiaries. Paying for education, buying a first home, or covering living expenses are common, rather than handing them a large sum.

A testamentary trust acts like a financial safety net. It can’t guarantee that no outside claim will ever succeed, but it significantly increases the protection around your estate.

The Australian tax system has special rules that favour income distributed from a deceased estate via a testamentary trust. A testamentary trust often has the flexibility to distribute income among various beneficiaries each year. The trustee can choose to allocate income in a tax-efficient manner. For example, the trust might distribute more income to a beneficiary with little to no other taxable income and less to another in the top tax bracket. The tax paid on the trust’s earnings can be reduced by spreading the distributions to lower-income beneficiaries. This income splitting is perfectly legal and can save your family a lot of money over the life of the trust.

Normally, if you set up a regular family trust or invest money in a child’s name, any investment income over a very low threshold is taxed at punitive rates. This discourages people from hiding money in their kids’ names. However, income from assets from a deceased estate through a testamentary trust is treated as “excepted trust income,” meaning minors get the same tax-free threshold and marginal rates as adults. For instance, in Australia, an adult and thus a child beneficiary of a testamentary trust can currently earn up to $18,000+ per year tax-free; this threshold can change with tax law updates. A testamentary trust with investment assets could distribute, say, $18,000 to each of several children or grandchildren, and each amount could be received tax-free or at very low tax rates. This is a huge advantage over a standard trust or outright gift.

When assets pass via your will to a testamentary trust, generally, there’s no immediate capital gains tax because it’s treated as a deceased estate transfer. Inheritances in Australia usually don’t trigger CGT at death if appropriately handled. The trust can also take advantage of the 50% CGT discount on assets held for over 12 months, just like an individual would. Additionally, if the trust later sells an inherited asset, it can stream capital gains to beneficiaries in lower tax brackets. The result is more flexibility in managing taxable gains or even franked dividends from shares by allocating them optimally among the beneficiaries.

The trustee typically prepares an annual tax return for the trust, but with careful planning, the taxable income can be allocated in the most tax-effective way. Over the decades, these tax savings have compounded, meaning more investment earnings stay with the family rather than going to the tax office. This tax efficiency complements the wealth creation goal: by saving on unnecessary tax, the trust grows faster for the beneficiaries.

It’s important to note that these tax benefits apply when the income is derived from the assets of the deceased estate. There are rules to ensure people don’t abuse testamentary trusts by pouring in unrelated assets just to get the tax break for minors.

While testamentary trusts are helpful, they don’t suit every circumstance and receiving professional advice is highly recommended. In broad terms, a testamentary trust should be considered if:

• Your children or grandchildren are under 18 or in their early adulthood. The trust provides structured financial support until they are mature enough to manage money responsibly. Rather than inheriting a large sum at 18, they can benefit from the trust’s assets over time as needed.
• You’re concerned about an adult child’s marriage or de facto relationship stability. If you’re leaving money to a son or daughter who is married or may marry, and you worry about divorce scenarios down the track, a trust can help safeguard that money. The same goes for a beneficiary with a complicated personal situation or a history of partners who may not have their best interests at heart.
• One of your intended beneficiaries has a disability, health issues, or simply poor financial habits; a testamentary trust can ensure their inheritance is managed wisely. A trust can provide lifetime financial support for a beneficiary with special needs while working with government benefits or support structures. There are specific types of testamentary trusts tailored for disabled beneficiaries.
• Perhaps your beneficiary is a business owner, a professional in a high-liability field like a surgeon or lawyer who could be sued, or someone prone to accumulating debt. By using a testamentary trust, you add a layer of protection against creditors or legal claims.
• High-net-worth individuals should seriously consider testamentary trusts. The larger your estate, the more you could potentially lose to taxes, lawsuits, or inefficient management.
• You live in a blended family. A testamentary trust can be helpful to balance and protect everyone’s interests. For example, you might want to provide for your current spouse and ensure your kids from a first marriage ultimately inherit whatever remains. A properly structured trust can grant your spouse income for life, but preserve the capital for your children later. In complex family situations, testamentary trusts add validity to your wishes.

When you need or want more control, protection, or flexibility in your estate plan, you should explore testamentary trusts. Even if you think your situation is straightforward. It stays folded until needed, but it can address various challenges when the time comes.

Estate planning isn’t just about writing a will. A testamentary trust can give your loved ones long-term protection and peace of mind.

At First Financial, we help Australians create estate plans that go beyond the basics. Our experienced advisers can help you make confident, informed decisions. To understand more about how we can help, contact our team today for professional, tailored advice specific to your circumstances.

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