The trust that could stop your kids blowing the family fortune

For families worried about divorce, bankruptcy, scams or poor money management, a testamentary trust can help protect wealth and reduce tax.

Leaving a lump sum of money to your children or grandchildren needs careful planning at the best of times. But it becomes a fraught decision if they or their partners have a substance or gambling addiction, other problems, or are simply clueless when it comes to money.

It isn't smart to give vulnerable beneficiaries a large amount of money because they can potentially blow up the family wealth. In a time of widespread scamming, they could easily be manipulated by an outsider who will rip them off.

They could need special estate planning to protect them.

One estate planning strategy that provides a level of protection after you die is to set up a testamentary trust in your will.

A testamentary trust can protect the capital and distribute an income to support family members on an ongoing basis. This means the money you leave your heir can't disappear quickly and leave them destitute for the rest of their lives.

One scenario would look like this:

"Your will might be the first few pages, and then it will be followed up with 15 pages of how the funds may be held in a testamentary trust under the following terms, and that will give powers to the trustee about what to do with the money and how it can be distributed," explains Peter Bardos, tax partner at HLB Mann Judd.

It turns out that testamentary trusts are the last frontier of trusts, explains Anna Hacker, client director at Pitcher Partners.

They are still standing with their tax and asset protection strategies intact after the government changed the tax status of 840,000 discretionary trusts, known as family trusts.

"A testamentary trust will be the only way to have both the tax planning and the asset protection," says Hacker.

The income from all sorts of testamentary trusts will be exempt from the minimum tax of 30%, starting from July 2028, on family trusts announced in the Budget.

Hacker says the estate planning industry is still waiting for final clarifications about the treatment of testamentary trusts from the government and recommends anyone with a testamentary trust may need to review it when this comes through.

Testamentary trusts are very different from family trusts because they only come into effect upon the death of the will-maker, who has stipulated a testamentary trust in their will for their assets.

A family trust can be set up while parents and their beneficiaries are alive, delivering an income.

The tax advantages of testamentary trusts

One of the benefits of a testamentary trust is that if the parents of young children tragically die, the testamentary trust is able to distribute an income to beneficiaries aged under 18 that is taxed at adult tax rates.

This means they can have at least $18,200 a year tax-free, or $36,400 tax-free for two children.

This way, under-18 beneficiaries can avoid high tax penalty rates on income going to children, which climbs to 66% for amounts between $416 and $1307, and then 45% for income over $1307.

"This is pretty handy from a tax perspective," points out Bardos.

"It could help with paying, for example, private school fees, in a more tax-efficient way."

The asset protection catch you need to know

The asset protection that testamentary trusts provide is a key factor for people who set them up.

They can offer some protection in instances of bankruptcy and relationship breakdowns.

"We live in a society where the rate of divorce is quite high, and we have lots of blended families. People want to support their bloodline if there's a relationship breakdown for any of their kids," says Hacker.

To protect lineal descendants, she says it's important to get the framework right for asset protection.

A testamentary trust for a single child may not necessarily be exempt and protected in a divorce.

Bardos agrees that testamentary trusts don't necessarily provide the protection that a lot of people think they do.

"If a child has a testamentary trust from their parents, and that child is the sole trustee, the sole beneficiary, and the trust pays for all of their lifestyle and perhaps their spouse's lifestyle, my understanding is that's more likely to be brought into a matrimonial dispute or separation than if that child perhaps didn't have that same level of control over the trust," says Bardos.

Hacker says it is popular to place all the children in a testamentary trust as equal beneficiaries to help protect the assets from a family court.

Appointing an independent controller of the trust, such as an independent trustee, can be viewed more favourably in family law cases.

"That is going to be far safer from an asset-protection point of view and what I'm seeing more and more," says Hacker.

But she says getting the protection right and ruling from the grave can cause issues for families.

She advises families that they need to be clear about whether putting all the children together in a testamentary trust is going to work.

"Is that going to cause friction within the family unit? Is that going to be opposite of what you want?

"I'm sure they might have a trust that's growing and supporting people, but is it actually going to make them hate each other if they are not able to interact properly?"

Testamentary trusts are not as flexible as discretionary trusts.

One limitation is that assets dealt with under a will need to be the asset of the will-maker, explains Bardos.

They can't be assets owned by their investment company or family trust.

"When you're going through the process of estate planning, understanding what actually can go into a testamentary trust is important," says Bardos.

Avoid onerous directions

Hacker says flexibility is key in a will, and giving the trustee discretion to direct assets either to a testamentary trust, directly to beneficiaries, or a mix of the two takes into account what is going on with the beneficiaries.

"They want to be able to choose the right approach at the time.

"Do they need to pay off their mortgage, in which case they might want it personally? Do they have a whole heap of expenses?

"You don't know what that's going to look like, so you have that discretion to decide where it's going to go later," says Hacker.

An alternative to testamentary trusts, Bardos says, is an inter vivos trust that can be set up during someone's lifetime and have terms whereby the capital stays in the trust and the income is distributed until an age set down by the trust.

An inter vivos trust allows parents to control the money while they are alive, and it can be locked in when they die.

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