Testamentary trusts have become an essential part of estate planning for many and are seen as tax effective. However you may be asking what that means for you and your family and when can they make a difference.
What is a testamentary trust?
A testamentary trust is created under someone’s will and comes into existence on their death. It allows you to set up a structure that enables family members such as your children and grandchildren to manage and distribute the assets they inherit from you and the associated income.
Income splitting
One of the most useful tax benefits of a testamentary trust is that it allows income to be divided among multiple beneficiaries, including minors.
Example – Ron’s Estate
Ron’s will states that his Estate should be divided equally between his two sons Tom and Andy. After after their father’s death either son can choose to transfer their inheritance into a testamentary trust, with the terms and beneficiaries outlined in Ron’s will.
When Ron dies Tom is aged 25 and is single, choosing to receive his share of the Estate directly, while his brother Andy is aged 28, married to April and has two daughters Donna (aged three) and Leslie (aged five). Andy asks the executor (Ron’s friend Chris) to pay most of his share of the Estate into a testamentary trust called the Andy Investment Trust (AIT), with Andy as the trustee.
Allocation of Estate assets
Ron’s estate is worth $26 million, including his home, two investment properties, a holiday cabin, shares, managed funds, $2 million in bank accounts, his Bentley, rare book collection and other personal effects.
Tom receives the house and Bentley, Andy receives the holiday cabin and some of his father’s personal effects, the AIT receives the rare book collection, and the remaining assets are sold by the Estate. After paying any tax and other expenses, the Executor distributes the remaining cash from the Estate to Tom and the AIT so as to ensure that each brother receives an equal share overall.
The AIT – investments, income & distributions to beneficiaries
This leaves the AIT with approximately $8 million in cash which Andy in his capacity as trustee invests in a diversified portfolio of shares and managed funds that generates annual taxable income of $600,000.
Andy is an executive earning a $250,000 salary and his wife April works part-time earning $20,000. With a regular investment trust April could receive taxable distributions of $170,000 before she reaches the top tax threshold of $190,000, leaving the majority of the trust income to be taxed at a high rate since distributions to minors above $416 are taxed at 45 per cent.
With a testamentary trust, however, Donna and Leslie will be taxed on their distributions at the normal marginal tax rates. For the 2025 year they can each receive taxable distributions up to $190,000 from the AIT without reaching the top tax threshold, on which they would each pay tax and Medicare levy of $55,438, which represents an average tax rate of 29.18 per cent. If a substantial portion of the income is franked the tax will be mostly offset by franking credits and the overall outcome is highly tax effective.
The AIT could distribute the remaining $220,000 to April, pushing her taxable income up to $240,000, only $50,000 of which would be taxed at the 45 per cent top marginal rate, which represents an annual tax saving of more than $67,000 compared to a regular investment trust where the additional income distributed to their daughters might otherwise be taxed to April herself. These savings can be repeated each year at least until the respective children turn 18, and potentially longer.
It is also worth noting that distributions to minors are not subject to the anti-avoidance rule in Section 100A that has been a strong focus area in recent years, allowing the income distributed to Donna and Leslie to be retained in the trust and reinvested to grow the portfolio without any risk of the ATO attacking the way in which the trust income has been allocated, all while keeping the assets safe for the benefit of Andy and his family, in particular building up a nice nest egg for his daughters’ future.
Conclusion
While there can be complexities and costs involved in setting up and operating a testamentary trust, they are a useful way to protect your assets after your death for your children and grandchildren and the tax savings on offer can be quite substantial. It is of course vital that you seek expert legal and tax advice when considering how this might best work in your particular situation, but if it is suitable and your will is prepared appropriately, your family may be grateful that you took this step.