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A testamentary trust is established within a will, allowing inheritance distribution over time, rather than all at once after the testator's death (the testator is the person who set up the trust).

This approach might be appealing if your beneficiaries can’t manage their own finances due to disability or age or aren’t, shall we say, the most fiscally responsible.

And it's not just cash that testamentary can hold. Real estate and shares are just some of the investment vehicles that can be included.

But the option to drip feed an inheritance isn’t the only benefit that a testamentary trust can provide. It can also offer significant advantages when it comes to taxation.

What is a testamentary trust?

A testamentary trust allows a person to provide a loved one a bequest without giving that loved one full and immediate access to that bequest. 

There are two common types of testamentary trusts: discretionary and protective.

  • Discretionary testamentary trust
    Trustees have control over fund management and distribution, which can offer tax benefits and asset separation.

  • Protective testamentary trust
    Designed for beneficiaries who cannot manage finances, such as minors or those with disabilities. A trusted person, such as a friend or family member, a solicitor, or a government-run public trustee, manages the funds. 

What tax benefits can testamentary trusts offer?

Like most-anything tax-related, the taxation of assets and income held or distributed by a testamentary trust can quickly get complicated. 

For that reason, it’s wise to seek professional advice if you decide to include a testamentary trust in your estate. 

H&R Block director of tax communications Mark Chapman outlined some of the benefits that testamentary trusts can provide under the correct guidance. 

“As a form of discretionary trust, a testamentary trust can enable the trustee to stream or split income amongst the trust's discretionary beneficiaries in a way that minimises overall tax paid on the trust's income,” Mr Chapman told Your Mortgage.

“The trustee may decide which beneficiaries receive trust income. The beneficiaries that receive the trust income then include this income in their own assessable income which is taxed at that individual's marginal tax rates.

“A trustee is able to minimise the overall tax paid on the trust's income by streaming income to beneficiaries with low marginal tax rates.

“With the current tax free threshold of $18,200, beneficiaries are potentially able to receive up to $18,200 of tax free income from the testamentary trust each year.”

Under a testamentary trust, beneficiaries are also able to make use of franking credits realised by the fund.

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How testamentary trusts can save underage beneficiaries tax 

In the case of underage beneficiaries, an interesting addition to taxation legislation sees income from testamentary trusts taxed as if the beneficiary were an adult.

That means they can take advantage of the tax free threshold and other benefits that they otherwise wouldn’t be able to.

“Income from a testamentary trust for children is classified as ‘excepted trust income’ and will be taxed at ordinary adult marginal rates against the trustee, entitling them to the $18,200 tax-free threshold they otherwise would not have been able to access,” Mr Chapman said.

“This compares to ‘normal’ trusts, where income can be taxed at up to the highest rate of tax of 47% (including the medicare levy) for minor beneficiaries (with only a $416 tax free threshold).”

Testamentary trusts and capital gains tax 

Like individuals, testamentary trusts are able to receive a 50% discount on capital gains tax (CGT) on the sale of assets it's held for more than 12 months, Mr Chapman said. It can also realise all of the small business CGT concessions. 

Further, a person receiving assets via a testamentary trust won’t need to pay CGT, as there is no capital gain of loss realised by the transfer of ownership.

How does a testamentary trust work?

Like most anything regarding estate planning, expert advice can be invaluable when it comes to testamentary trusts. 

With that said, here are the basic details a person considering setting up a testamentary trust might want to know. 

How are testamentary trusts managed?

The terms of an individual testamentary trust will dictate how assets are to be distributed to beneficiaries and how much control trustees have over the management of the trust.

How can testamentary trusts protect assets?

Another benefit of a testamentary trust is that such trusts can protect beneficiaries from future changes.

A testamentary trust ensures assets are used as intended. It protects beneficiaries from potential future claims, such as by a new partner of a surviving spouse, and safeguards assets from beneficiaries' creditors

How to make a testamentary trust 

Aussies would be wise to turn to professionals for their expertise when setting up a testamentary trust. 

A small mistake made now could have major consequences for a person’s loved ones after they pass away. 

Qualified and experienced professionals can ensure a testamentary trust properly aligns with your intentions and complies with relevant laws and regulations.

  1. Draft a valid will

Testamentary trusts are established through valid wills, so the first step is to make one is to set up a will.

It’s probably worth turning to  a qualified legal professional to draft a will that includes provisions for the trust.

The will should clearly outline the trust’s terms and conditions, including who will be its trustees, who will be its beneficiaries, and how its assets will be distributed. 

  1. Appoint trustees

Perhaps the most important part of setting up a testamentary trust is choosing the people (or the corporation/s) that can act as its trustees.

These trustees will have a duty to manage the trust assets in the best interests of the beneficiaries.

  1. Specify trust terms

Being specific about the ‘whys’ and ‘hows’ of a testamentary trust can help ensure your intentions are understood and your trustees and beneficiaries know how the trust will be managed and distributed.  

Define the objectives of the trust within the will, including how assets will be managed, invested, and distributed, and any conditions or restrictions on distributions.

  1. Identify beneficiaries

Make sure it’s clear who will receive the benefits of the trust. Beneficiaries might include family members, dependents, charities, or other entities.

Specify each beneficiary’s entitlements and any conditions attached to their distributions.

  1. Execute the will

Sign and date the will in the presence of witnesses, as required by law. 

Ensuring a will is properly executed now makes it more difficult for any to challenge its validity later on. 

  1. Review and update regularly

As time wears on, your personal circumstances, family dynamics, and even relevant laws can change.

For that reason, it’s important to periodically review and update your will and testamentary trust provisions.

Image by Federico Giampieri on Unsplash