Your death is an opportunity. You probably don’t see it that way yet.
It’s an opportunity for your children to use some sizeable tax breaks that exist lawfully in the Australian taxation system.
An inheritance left to a child outright is taxed at that child’s marginal rate for the rest of their life. A discretionary testamentary trust lets the income be spread across their whole family instead, including their children, which can cut the tax on it substantially.
What happens under a simple Will?
Any income earned on the inheritance is taxed as though your child had earned it. Let’s consider an example.
Harry and Sally have two grown-up children, Adam and Beth. Beth is happily married with three children. She has a good stable job on a very high income, she and her husband own their home outright and the family enjoys a good lifestyle.
Under a simple Will leaving everything to the two children equally, Beth receives about $1,000,000. She invests it and earns income of, say, $40,000 a year.
Beth is already on a high income and paying tax at the top rate. Of that $40,000, roughly half goes to the taxman. Every year, for as long as she holds the money.
How can Harry and Sally improve on this?
Harry and Sally make Wills that include a discretionary testamentary trust or DTT, for Beth’s share, instead of giving the money to Beth outright.
Beth, her husband, her children and others are all beneficiaries of the trust. On the parents’ death, Beth’s inheritance is paid into it rather than into her own name.
Each year the income of the trust is distributed between Beth and her family members and the tax on it falls accordingly. Beth still controls the money. What changes is who the income is taxed to.
Why does this work?
The advantage comes from the children. Income distributed to a minor from most trusts is taxed at penalty rates designed to stop exactly this kind of splitting. Income distributed to a minor from a testamentary trust isn’t. It’s taxed at ordinary adult marginal rates, with the benefit of the tax-free threshold.
Beth has three children. That’s three more people the trust income can be spread across, each starting from zero rather than from Beth’s top rate. The saving repeats every year for as long as the trust runs.
Tax is Commonwealth law rather than Western Australian law and the rates and thresholds change. The structure is worth reviewing with your accountant as well as with us.
What are the limits?
The concession applies to income generated by the assets that came out of your estate. Money injected into the trust from elsewhere doesn’t get the same treatment, so the trust can’t be used as a general family tax structure.
The trust also has to be worth running. It lodges its own tax return each year and somebody has to keep the records. Where the inheritance is modest or won’t produce much income, the administration can outweigh the saving.
None of this is aggressive or unlawful; it’s a concession Parliament built into the tax system for exactly this purpose and it only works if the trust is set up properly in your Will while you are alive.
We explain more about what DTTs are and how they work in Everything you need to know about testamentary trusts.
Frequently asked questions
Does my child have to take the trust?
Not if your Will gives them the choice. A Will can offer each beneficiary the option of taking their share through a trust or outright, decided after your death when they know their own circumstances.
Is this only worth it for large estates?
It depends on the income the inheritance will produce rather than the size of the estate. A share that generates little or no income won’t produce much saving and the trust still has to be administered, but the asset protection benefits can still make the trust worthwhile.
Can a trust protect the inheritance as well as save tax?
Yes. The same structure gives the strongest available argument that the inheritance isn’t available on a beneficiary’s divorce or bankruptcy. See Estate planning trap no. 4 – rocky marriages.
Can I set up the trust now?
A testamentary trust is created by your Will and comes into existence when you die. No assets need to change hands during your lifetime and you can change your mind by making a new Will.
Talk to us before you decide
Whether a testamentary trust is worth it depends on your family and on what your estate will produce. We’ll tell you if it isn’t.
Book an appointment or call the Wills team on (08) 9220 4433.
See our Testamentary trust Wills service and pricing.
This article is general information and not legal advice. It isn’t tax advice either and you should speak to your accountant about your own circumstances.
