As the baby boomer generation approaches the twilight of their lives, the importance of proper estate planning has never been more critical. Testamentary trusts are often overlooked but may be invaluable, offering not only effective wealth management but also significant tax advantages for the beneficiaries.

What is a testamentary trust?

A testamentary trust is a trust created through a Will following the deceased’s passing and the completion of estate administration. It is governed by the terms outlined in the Will.

This typically involves certain assets owned by the decease being transferred into the testamentary trust for the benefit of certain beneficiaries as outlined in in the Will.

While it can be a fixed or discretionary trust, a discretionary testamentary trust is more common in practice as it offers flexibility in income distribution for tax planning purposes.

What are the benefits of establishing a testamentary trust?

In addition to tax planning benefits discussed further below, a testamentary trust offers asset protection from creditors and, in certain cases, shields assets from family law claims after a marriage breakdown.

It also allows the deceased some control over the future use of estate assets, such as by establishing life interests or appointing professional trustees to manage significant assets if there are concerns regarding the beneficiary’s ability to manage them responsibly.

The above features should be consulted and advised by legal advisors with appropriate expertise in this area.

What makes testamentary trust attractive for tax planning?

The main reason a testamentary trust is attractive from tax planning perspective is the concessional tax treatment of certain income distributed from testamentary trusts to children under 18 (minors).

Subject to certain exceptions, distributions from a standard discretionary trust is usually taxed at penalty rates to prevent parents from diverting income to children.

See link to the table for tax rates for residents who are under 18: Tax rates if you’re under 18 years old | Australian Taxation Office (ato.gov.au)

However, distribution from a testamentary trust originated from the testator’s assets transferred under a Will is considered as excepted income to minors and is taxed at adult’s marginal tax rate.

See link to the table for resident tax rates: Tax rates – Australian resident | Australian Taxation Office (ato.gov.au)

For example, Joe recently passed away and a discretionary testamentary trust was set up under his will for the benefit of his wife & three young children. In an income year, the testamentary trust derived $50K net income. Assuming 100% of the income was derived from the properties transferred from Joe’s estate and his wife is already at the highest marginal tax rate, the $50K net income can be distributed equally to their three kids tax free instead of being taxed at $22,500 at minors’ penalty rate.

Tips and traps

  1. The Government revised the law effective 1 July 2019, restricting tax concessions for minors to income generated from assets transferred from the deceased estate to the testamentary trust. Consequently, income from assets introduced to the trust from external sources, such as distributions from other trusts, gifts, or loans, will be subject to minors’ penalty tax rates.
  2. Careful planning to choose which assets should go to testamentary trust is required to avoid unwanted tax implications, such as:
    • Main residence exemption is not available to trusts, including testamentary trust.
    • Transferring business premises to a testamentary trust may impact the eligibility to access the Small Business CGT Concessions in some circumstances.
  3. Superannuation is dealt with separately from a person’s will unless it’s paid to the person’s estate. When determining whether to include superannuation as an asset to go to a beneficiary’s testamentary trust, it’s vital to account for potential tax implications, particularly if any beneficiary of the trust is a non-tax dependent (e.g., an adult child), and explore alternative strategies for managing superannuation benefits.
  4. Surcharge land tax rate may be applicable to testamentary trusts with land holding previously held under personal names, subject to applicable PPR nomination, as well as additional land tax for trusts with non-resident beneficiaries.

Conclusion

Testamentary trusts offer a myriad of benefits including tax efficiency, asset protection, and controlled distribution. As the baby boomer generation transitions into the next phase of life, harnessing the power of testamentary trusts ensures that their legacy endures and their loved ones are provided for according to their wishes. Proper estate planning with testamentary trusts is not just about securing financial assets; it’s about safeguarding family legacies for generations to come.

Given the individual unique needs and complexities involved, we recommend collaborating with your legal adviser, tax adviser and financial planner to achieve your desired outcomes in the most tax efficient way that meets the needs of the next generation.

Credit Monika Lam Manager Tax Consulting for co-authoring.