A common concern for parents is that after they die their child will become separated from their spouse or partner or fall into financial misadventure and lose a substantial part of their inheritance.
This fear is not surprising as most people would not be comfortable with the possibility and even the thought that a stranger may run off with their family’s hard-earned wealth.
The taxation implications of a transfer of assets from one generation to another are also becoming increasingly important. Previously, a simple will may have been sufficient for most needs, but individuals and families are now holding greater amounts of wealth and using more sophisticated structures than ever before.
When you consider that Australia is experiencing one of the most significant inter-generational transfers of wealth that we have ever seen, tax-effective and asset-protective estate planning will be a high priority for many.
A simple will is the most common type of will prepared by lawyers and is what all ‘newsagent’ or ‘form’ type wills are. Although these types of wills do not prevent complicated provisions from being made, the expectation is that the testator (the will writer) will make ‘absolute’ or ‘outright’ gifts to beneficiaries.
While simple wills are often cheap and quick to implement, they can give rise to serious problems, as they offer no tax-effectiveness or asset protection for the recipient beneficiaries.
If a testator were to die with a simple will in place, their beneficiaries would have no choice but to take their inheritance in their personal names, and any income generated by those beneficiaries on their inheritance (such as rental returns on property, interest or dividends) would be taxable in the hands of those beneficiaries at their marginal rate.
Depending on the size of the estate, this could result in beneficiaries going from low rates of tax to the top rate of tax.
Example: Tax implications of a simple will
John is single and has two adult children, Sam and Ben. John’s estate consists of his principal place of residence worth $1.5 million, an investment property worth $500,000, a portfolio of shares valued at $600,000 and various term deposits and cash saving accounts.
The estate generates a total income of $80,000, made up of rental income on the properties, dividends and interest on the term deposits and bank accounts.
John has a simple will which divides his estate equally between his children Sam and Ben.
When John drafted his will his solicitor did not consider that Sam and Ben each earn $140,000.
John dies and his executor obtains a grant of probate. Sam and Ben share the estate; each takes the $40,000 income generated by their shares.
Given that Sam and Ben each earn $140,000, the $40,000 in earnings on their inheritance is added to their income and they pay tax on $180,000. In addition to this, if Sam or Ben were to marry and subsequently get divorced, under a simple will their inheritances would be vulnerable to and available for any divorce settlement.
Will with discretionary testamentary trust
A well-drafted will with discretionary testamentary trusts can provide tax-effectiveness and asset protection for beneficiaries.
How does it work?
A discretionary testamentary trust provides a greater level of asset protection than an outright gift. This is because the trustee, and not the beneficiary, is the legal owner of the asset. A trust therefore enhances the level of asset protection that a beneficiary will have from various threats, including a beneficiary’s wasteful habits or addictions, claims by creditors in bankruptcy proceedings or claims by spouses in a marital breakdown.
A discretionary testamentary trust allows a beneficiary to split and stream income and capital to the potential beneficiaries of the trust. The tax-effectiveness of testamentary trusts arises out of the fact that rather than paying marginal rates of tax on the income generated by their inheritance (as would be the case under a simple will), when assets of a testamentary trust are sold, or where income is generated from trust assets, the trustee has the ability to strategically pass out such taxable income to those beneficiaries who will pay the least tax. This becomes particularly tax-effective where the beneficiary has a spouse who does not work (or is on a lower tax rate) or where they have minor children (a testamentary trust treats distributions to minors as if they were adults).
Example of tax-effectiveness
Let’s assume that John sought advice on his estate planning and had a will with discretionary testamentary trusts prepared.
John’s will would offer Sam and Ben the option to take their inheritance outright or via a testamentary trust.
As Sam has two children, he is able to have trust income distributed equally between his two children. Sam distributes $20,000 to each of his children and since they are able to receive $18,200 ($20,542 with the low-income tax offset) tax free, he is able to receive the entire $40,000 tax free.
Get your affairs in order now!
Make putting in place an estate planning strategy your priority and ensure that should the unexpected happen, you have secured your family’s future by providing them with tax and asset protection.
Chamberlains is nationally recognised as a leading estate planning firm. We literally wrote the book on wills and are the authors of the only dedicated text on testamentary trusts, Testamentary Trusts: Strategies and Precedents (Lexis Nexis 2016).
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Vik Sundar is Managing Director at Chamberlains Law Firm. This is a sponsored article. For information on paid posts, see our sponsored content policy.