Knowledge

13 June 2018

How to reduce tax and protect your wealth for future generations through the use of a testamentary discretionary trust

Do you want to minimise tax implications and ensure that your hard earned assets are passed on to future generations in a protected environment?  If your response was “Yes!”, then a testamentary discretionary trust might be just what you need in your estate plan.

What is a testamentary discretionary trust? 

A testamentary discretionary trust (or “TDT”) is a trust that is created by the provisions of a will and only comes into effect upon a person’s passing, as opposed to during their lifetime.

Like a normal trust, a TDT provides for a range of beneficiaries, in addition to the primary beneficiary, all of whom are discretionary beneficiaries – so that it is up to the trustee of the trust to determine in any particular year who should receive the income or capital of the trust.

The beneficiary of a testamentary discretionary trust does not have any defined interest or fixed entitlement to the trust assets unless and until the trustee makes a determination in their favour.  The beneficiary merely has a right to be considered and have the trust administered in accordance with the terms of the trust.

What are the advantages of a testamentary discretionary trust?

Asset protection

I find that the main reason clients choose to implement TDTs in their wills is for asset protection.  By giving a primary beneficiary of the estate the option to inherit via a TDT, the primary beneficiary does not have to inherit those assets personally.  This would be attractive if you have a beneficiary who:

  1. faces the prospect of financial difficulties or bankruptcy arising from carrying on business, giving guarantees or failure of insurers;
  2. faces difficult family or domestic circumstances (e.g. the breakdown of a marriage or de facto relationship);
  3. is poor at handling their finances;
  4. suffers from an addiction; or
  5. has the prospect of a contested personal estate when the primary beneficiary subsequently dies.

Example of how it works – asset protection

To illustrate the benefits of a TDT where a spouse has a high risk profile and exposure to bankruptcy, I will use the factual scenario of Tom and Jane.

  • Tom and Jane are married with two children, Jack aged 9 and Kate aged 12.
  • Tom is a director of a company and has a high risk profile.
  • Tom and Jane are looking at buying a new house. Their accountant suggests that Jane purchase the house in her name (as the low risk spouse) so that the house is not exposed to creditors.
  • This asset protection measure could unravel if Jane passes away and leaves everything to Tom absolutely, as the house would then be exposed to creditors.
  • Instead, if Jane gifts her assets into a TDT (of which Tom, Jack and Kate are beneficiaries) then Tom will not have direct ownership, which offers better protection of the house against creditors.

Income tax benefits

There are also significant taxation benefits, particularly where any beneficiary is under the age of 18 years.  Unlike a family trust (set up in your lifetime), children under the age of 18 are eligible for tax concessions for the income they receive from a TDT.  Income received by minors through a TDT is taxed at normal adult rates, which means that they are entitled to receive the benefit of the tax free threshold.  A TDT enables the trustee to stream or split income amongst the beneficiaries, depending on their personal marginal tax rate, to reduce the amount of tax incurred.

Example of how it works – income tax benefits

  • Jane had a life insurance policy worth approximately $400,000.00. After Jane passes away, those proceeds are invested, earning 7.5% of income per year (i.e. $30,000.00).
  • If Jane did not include a TDT in her will and gifted everything to Tom, then Tom would have to pay tax on the income generated, $30,000.00, at his personal marginal rate. If Tom is already a high income earner, that could be at 47%, which is $14,100.00.
  • Instead, if Jane has a TDT set up in her will, the trustee could resolve to distribute this income equally between Jack and Kate to be used towards their schooling fees.
  • As Jack and Kate have no other income, the distributions to them ($15,000.00 each) are tax free, as each distribution to the child is below the current tax free threshold of approximately $20,000.00.

As you can see, TDTs can allow for some significant tax savings.

Should I have a TDT in my will?

In my experience, TDTs generally appeal to people who:

  • want to pay less tax;
  • have children or plan on having children;
  • want to ensure that their assets are protected for future generations;
  • have beneficiaries who are high income earners; or
  • don’t trust their beneficiaries with money.

TDTs can be quite flexible and therefore appeal to a diverse range of people.  It is important to remember that TDTs cannot be created retrospectively and must be included in the willmaker’s will before death.  For this reason (and the fantastic benefits of TDTs outlined above), TDTs should at least be considered by every person when they prepare a new will.

If you would like more information about TDTs, please do not hesitate to contact Bianca Stafford, an Associate in our Wills and Estate Planning team.

*Disclaimer – The information provided in the document is current at the date of publication and is a general summary which is not intended to be nor should it be relied upon as a substitute for legal or other professional advice.

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