The introduction of the $1.6 million transfer balance cap will affect the insurance and estate plans of many superannuation members. In my last article, I discussed why members must review any insurance they hold in super. Additionally, the transfer balance cap places a limit on the amount that can be paid as a death benefit pension and any excess benefits must leave the super system.
This article outlines how the use of testamentary trusts can provide estate planning certainty for super members with minor children and also allow for tax-effective distribution of income among family members.
What is a testamentary trust?
A testamentary trust is a trust that is created within a person’s Will but does not take effect until after their death. A testamentary trust may be created using specified assets, a designated portion of an estate or the entire remaining balance of an estate. Multiple testamentary trusts may be set up by the one Will.
What are the advantages of a testamentary trust?
There are some advantages creating a testamentary trust including:
- Protection of beneficiaries
Many parents appreciate the tax efficiency of paying death benefit pensions to minor children but balance this with their fear of what their children may do with a large sum of money. A death benefit income stream can be commuted at age 18, which is not an age that many parents feel their child would make responsible financial choices (red sports car anyone?).
Directing some or all of the super balance to a testamentary trust can address this issue because the parent can control when a child has access to funds. A testamentary trust is particularly important for clients affected by the $1.6 million transfer balance cap where excess monies must leave the super system.
Clients may have other beneficiaries who will benefit from not having direct control over an inheritance. These can include spendthrift beneficiaries, those with gambling, alcohol or drug addictions or people who are easily influenced by others.
Trusts can retain taxable income or it can be allocated to the beneficiaries in a tax-effective manner. The trustee can be given discretionary powers about the distribution of income, which makes the testamentary trust a flexible tax-planning vehicle.
Beneficiaries pay income tax at their individual marginal rates on the amount of income they receive from the trust. However, unlike tax on income from other sources, beneficiaries of testamentary trusts under age 18 are taxed at normal adult rates rather than the penalty tax rate applied to minors. As a result, the potential for tax savings when trust income is allocated to children can be substantial.
- Flexibility for a primary beneficiary
If included within the terms of the trust, the trustee can exercise discretion as to the distribution of income to beneficiaries at any time and in any proportion. There may be tax planning reasons for a primary beneficiary, such as a surviving spouse, to request the allocation of income to other beneficiaries.
As the beneficiaries do not legally own the assets of the trust, testamentary trusts provide a level of protection in the event of a beneficiary’s relationship breakdown. Assets are held in a trust and the income and capital are distributed at the discretion of the trustee (who would typically not be the child in the difficult relationship).
The use of a testamentary trust can also be helpful for clients with beneficiaries who are at risk of bankruptcy. If a Will leaves assets directly to a beneficiary, if they become bankrupt, their inheritance may pass straight through to the trustee or to creditors. Assets held in a testamentary trust are usually better protected.
Case study - Margaret
Margaret is a single parent aged 42 who has two minor children. She has an accumulation account which holds $400,000 and life insurance of $2 million.
If Margaret dies, each child will be limited to a death benefit pension of $800,000 (half of the $1.6 million transfer balance cap). The remaining $400,000 for each child must leave the super system as a lump sum payment.
It suits Margaret’s plans for each of her children to have $800,000 as a death benefit pension, but she does not want them to have immediate access to the additional $400,000. Margaret changes her death benefit nomination to direct the excess to her estate and establishes a testamentary trust for each child via her Will.
Conclusion
The introduction of the super changes from 1 July 2017 is a catalyst for super fund members to review their estate plans. Professional estate planning advice can provide members with peace of mind that their super death benefits will be distributed to beneficiaries as per their wishes in the most tax-effective way.
Julie Steed is Senior Technical Services Manager at Australian Executor Trustees. This article is general information and does not consider the circumstances of any individual.