A testamentary trust is a trust set out in your Will that stays dormant until you die. In Western Australia it is used to hold an inheritance for your family rather than paying it out to them directly, which can reduce the tax your family pays and make the inheritance harder for a creditor or a former spouse to reach.
What is a testamentary trust?
A testamentary trust is a trust created by your Will that only comes into existence when you die. Testamentary trust, testamentary discretionary trust, TT and TDT are all lawyer speak for the same thing. We call it a discretionary testamentary trust (DTT).
A DTT is very similar to a family trust, generally known as a discretionary trust, except that it is established by your Will and lies dormant until you die. You only get one chance at it: the trust must be in your Will when you die and it cannot be added to your estate afterwards.
A DTT can be drafted narrowly or broadly. It can be fixed or discretionary as to the payment of income and capital, the class of people who can benefit can be wide or limited and it can have different classes of beneficiary, such as one entitled only to income and another only to capital.
How does a testamentary trust work?
A testamentary trust works by separating control of the assets held in the trust from the benefit of them. Under a simple Will your executor takes charge of your assets, pays your creditors and then divides what is left among your beneficiaries. Under a Will containing a DTT your executor pays your creditors as usual, then transfers control of the net assets to the trustee of the trust instead of paying them out to the beneficiaries directly.
Once that transfer has taken place the role of your executor is practically complete. The trust then operates much the same way as a typical discretionary family trust.
The roles in a testamentary trust are generally:
| Role | What they do |
|---|---|
| Appointor | The ultimate controller of the trust. Appoints and removes the trustee and can replace the trustee at any time. An optional role. |
| Trustee | The legal holder of the trust assets. Responsible for day to day management and administration, with discretion over payments of income and capital. |
| Beneficiaries | Receive income and capital only at the trustee’s discretion. No right to demand a distribution and they do not own any of the trust assets. |
An effective testamentary trust has many people who can potentially benefit and each entitlement is at the complete discretion of the trustee. A beneficiary is not a fixed person with a fixed share. Everyone in the class is entitled only to be considered. The trustee determines who actually receives distributions.
A trustee can also be one of the beneficiaries. Where that happens the trust assets look and feel more like that person’s own assets, because they are in control and can choose themselves or their family to benefit. That control has a cost though, which is the most important decision you will make about a testamentary trust. We have written about it separately in who should be the trustee of a testamentary trust.
How does a testamentary trust reduce the tax your family pays?
A testamentary trust is a flow through vehicle for tax, which means the income earned each year from investing the trust assets has to be distributed to beneficiaries and each beneficiary is taxed on what they receive at their own marginal rate. Each year the trustee chooses which beneficiaries receive that income, meaning they can choose to distribute the income to the people on the lowest tax rates.
A testamentary trust also offers a benefit no other trust has. Beneficiaries under 18 are taxed as adults on income from the assets that came from your estate, so each child can receive roughly the first $22,800 of that income tax free each year. The concession applies only to income from assets that came from your estate, not to money added from elsewhere.
None of this is available to you while you are alive. The tax treatment exists only because someone had to die for the trust to start.
The trust can last for up to 80 years, so your children can in turn apply tax free amounts for their own children while those children are under 18.
How does a testamentary trust protect an inheritance?
The protection comes from the discretionary nature of the trust. Because no beneficiary owns the trust assets and each one has only a right to be considered by the trustee, it is difficult for someone to argue that the trust assets belong to any one beneficiary.
If your child runs a business, sits on a board or works in a profession exposed to negligence claims, an inheritance held in a trust is generally beyond the reach of their creditors if things go wrong. An inheritance paid to them directly is not.
The position on divorce and separation is less clear cut. A trust does not automatically put an inheritance beyond the reach of a family law claim, but it can certainly help. The Court will look closely at who controls the trust. The more control your child has over their own trust the easier it is for the Court to treat the trust as property of the marriage or as a financial resource available to your child.
No structure protects an inheritance completely, but a trust is often the best strategy available. How well it works depends to a large extent on who you put in control.
What happens if your children are still young?
A testamentary trust is particularly useful if your children are young, because it keeps the inheritance in trust for them rather than handing it over as a lump sum. If your children are young, a testamentary trust:
- keeps the inheritance in trust for your children if your surviving spouse re-partners, away from the influence of a new partner and away from future family law risk;
- stops your children receiving their inheritance outright the moment they turn 18, so you choose who makes the financial decisions until they are ready; and
- lets the income from investing the inheritance be applied to their living and education expenses out of tax free income.
If you die leaving a spouse and three young children, roughly the first $22,800 of income for each child could be tax free and used for their living and education expenses. Without a trust your spouse pays tax on that income at their own marginal rate and meets those expenses out of what is left.
What are the disadvantages of a testamentary trust?
A testamentary trust will cost more to set up and more to run than a simple Will, so it is only worth it if the tax savings or the protection justify the extra cost. The things to weigh against the benefits are:
- legal fees to establish the trust and transfer assets to it;
- accounting fees and a tax return every year the trust holds assets;
- a superannuation death benefit paid into the trust may be taxable if any beneficiary of the trust is not a death benefit dependant, so paying super into the trust can be less effective; and
- the trustee has wide discretion over who receives income, so the choice of trustee is critical.
We will help you work out if a testamentary trust is right for you and your family.
Who should consider a testamentary trust?
Testamentary trusts are not just for complex estates or for the very wealthy. A testamentary trust is worth discussing with us if you tick any of these boxes:
- you are leaving at least $1,000,000, including your superannuation and any life insurance, to one or more people;
- you want to leave an inheritance to children under 18, each of whom could then receive tax free income from investing it;
- it matters to you that the inheritance is protected from relationship risks such as divorce or separation;
- it matters to you that the inheritance is protected from bankruptcy risks; and
- you are leaving assets to a beneficiary who may not be ready to manage a lump sum and you are worried it will be wasted.
Frequently asked questions
Can you make a testamentary trust optional?
Yes. Your Will can leave it to the beneficiary you have named and your executor to decide together, after you die, whether to use the trust or take the inheritance outright. The decision is then made knowing that beneficiary’s circumstances at the time, rather than being locked in when you sign your Will.
Can I set up a testamentary trust now, while I am alive?
Yes and no. A testamentary trust starts only on your death, but it must be in your Will when you die, so you do need to “set it up” while you are alive. A trust you set up and commence while you are alive is a family trust, which is taxed differently and does not carry the concession for beneficiaries under 18.
Does a testamentary trust have to lodge a tax return?
Yes. The trust is a separate entity for tax purposes and lodges a return for every year that it holds assets.
How long does a testamentary trust last?
A testamentary trust can last for up to 80 years from your death. At the end of that period the trust ends and the assets are distributed to the beneficiaries who are entitled to them at that time, if they haven’t already been distributed before then.
Talk to us about whether a testamentary trust is right for you
A Will containing a testamentary trust isn’t a simple Will, so we start with an estate planning consultation. We look at who your beneficiaries are, what you are leaving them and whether a trust in your Will is worth the extra cost in your case. Call the Wills team on (08) 9220 4433 or read more about testamentary trust Wills.
Related: who should be the trustee of a testamentary trust?
This article contains general information about discretionary testamentary trusts. It is not legal advice. You should obtain professional legal, taxation and financial advice about your estate planning.
