Testamentary Trusts

How a testamentary trust works

Under the will, part or all of the estate is directed to be held on trust for a primary beneficiary and a wider class — commonly the beneficiary's spouse, children and grandchildren. The primary beneficiary is usually appointed trustee, giving them practical control while retaining the flexibility of a discretionary trust. Income and capital can be distributed among the class each year, subject to the terms of the trust.

When a testamentary trust may be appropriate

• Minor beneficiaries. Income distributed from a testamentary trust to a minor is generally taxed at adult marginal rates rather than the punitive rates applied to unearned income of minors under Division 6AA of the tax law. This can produce meaningful tax savings where children are inheriting significant assets.
• Asset protection. A properly structured testamentary trust can offer some protection against a beneficiary's creditors, provided the beneficiary does not have effective control over their share as if it were their own.
• Family law risk. A discretionary interest in a testamentary trust is generally not treated as property of the beneficiary in a family law property division in the same way as an outright inheritance, though it can be a financial resource. The extent of protection depends on the drafting and on how the trust is administered.
• Blended families. A testamentary trust can allow a surviving spouse to enjoy income from the estate during their lifetime while ensuring the capital ultimately passes to the will-maker's own children.
• Vulnerable beneficiaries. Where a beneficiary has a disability, an addiction, or a history of poor financial decisions, a trust with an independent trustee can protect the inheritance and provide managed distributions.

When a testamentary trust may not be appropriate

• The estate is modest and the ongoing administration cost outweighs any tax benefit.
• Beneficiaries are adult, financially stable and prefer simplicity.
• There is no minor income to protect and no realistic creditor or family law risk.

Practical considerations

• A testamentary trust requires annual accounting and, in most cases, a tax return.
• The trustee has statutory and equitable duties that need to be observed.
• The choice of primary beneficiary as trustee versus an independent trustee changes the effectiveness of any asset-protection strategy.
• Multiple testamentary trusts can be created in a single will — often one for each adult child — so each beneficiary can decide whether to activate their trust.

Optional testamentary trusts

A will can be drafted so that each beneficiary elects, after the will-maker's death, whether to take their share directly or through a testamentary trust. This preserves flexibility without forcing complexity on beneficiaries who do not need it.

When a testamentary trust is worth considering

A testamentary trust is a trust created by the will and taking effect on death. It is used in Victorian estate planning where the will-maker wishes to hold a beneficiary's inheritance in trust rather than distribute it outright. Common reasons include the distribution of income to minor beneficiaries on more favourable tax terms than an ordinary trust, protection of an inheritance from a beneficiary's creditors or matrimonial disputes, provision for a beneficiary with a disability, and the staged distribution of capital over time.

Structural choices

A testamentary trust can be structured with a single trustee, joint trustees, an independent trustee, or a mechanism for the primary beneficiary to appoint and remove the trustee. It can be discretionary or fixed. It can allow the beneficiary to collapse the trust after a defined age, or require it to run for a longer period. Each choice has consequences for control, tax treatment, creditor protection and family provision risk, and the choice should be made deliberately.

Taxation and separate advice

The tax treatment of income distributed by a testamentary trust, and the concessions available for income distributed to minor beneficiaries, are set by taxation legislation and change from time to time. The interaction with capital gains tax, particularly on the transfer of assets into the trust and later distributions, is technical. Testamentary trust structuring should not be finalised without confirmation of the current tax position by the client's accountant.

Practical operation

A testamentary trust that no-one is willing or able to administer provides no benefit. Before the will is signed, the will-maker should confirm that the intended trustee is capable and willing to act, that an accountant will be engaged to prepare annual financials and tax returns for the trust, and that the beneficiary understands the ongoing obligations. For smaller inheritances the cost of running a testamentary trust may outweigh the benefit.

Interaction with other parts of the plan

Testamentary trusts sit alongside other estate planning tools — binding death benefit nominations, family trust deed variations, life insurance, and shareholders agreements. A change to one part of the plan often requires a change to the others, and periodic review is important.

Limitations of general information

The commentary on this page is general and is not tax, accounting or financial product advice.