Advantages of testamentary trusts

12 September 2022 by National Bank
testamentary trust

A testamentary trust allows you to decide how your estate will be used after your death. It's a very useful tool to protect vulnerable heirs. Here's a brief overview of the advantages of testamentary trusts and how they work.

What's the purpose of a testamentary trust?

What is a testamentary trust?

A testamentary trust is a legal vehicle that allows you to transfer all or part of your assets upon your death so they can be administered in accordance with your wishes. It is generally created in your will.

Two key features:

  • The trust takes effect upon your death. It will be managed by an intermediary determined in advance (the trustee).
  • The trust lasts until all assets have been distributed to your heirs. A payment schedule and a time limit on the life of the trust must be established.

To learn about another type of trust, see our article: What are the benefits of a family trust?

What are the advantages of a testamentary trust?

A testamentary trust is especially useful in the following 4 situations:

1.  Your beneficiaries are unable to manage the inheritance

Do you think one of your heirs will have trouble managing a budget ? You can put constraints on their inheritance payments.

You could specify that the capital won't be distributed until your heir completes their education and embarks on a career.

A testamentary trust is a good option for heirs who lack financial maturity, are living with a disability, are vulnerable or are living with a substance addiction.

It also allows your wealth to last longer by paying out portions over time.

2.  Your beneficiaries are minors

Are your heirs underage? You can use a testamentary trust to set aside a portion of the estate for their education and another portion to provide them with an income.

You could also stipulate that the capital won't be distributed in its entirety until five years after they complete their education.

This is particularly useful if you want to avoid a situation where your children find themselves with $200,000 apiece in their bank account at age 14 and spend it all before they become adults.

Good to know: When setting up a trust, it is important to give clear directives and anticipate as many situations as possible. For example, if you want the capital to finance your child's education but they quit school, you can set a specific age when they can access their inheritance.

3.  Your beneficiaries have debts

Are your beneficiaries in a lot of debt, or does their profession make them more vulnerable to lawsuits? Amounts held in a trust cannot be seized. Your inheritance will therefore be safe from your beneficiaries' creditors.  Wealth placed in a trust is also safe from the division of assets during a divorce.

A testamentary trust is a legal entity with its own assets. The bequeathed inheritance therefore remains separate from the beneficiary's wealth.

4.  Blended families

Do you have a blended family? A trust is a good option in this situation.

For example, you could decide that your surviving spouse can draw income from the trust, but that upon their death the assets will be transferred to the children from your first marriage.

How does a testamentary trust work?

The conditions of a testamentary trust are set in your will or by legislation.

Three parties are involved:

  • The transferor. This is the testator, the person who sets up the testamentary trust in their will and decides on the rules governing it.
  • The trustee. Named by the transferor, this party is responsible for administering the wealth in the trust in accordance with the testator's wishes. The trustee can be a friend, a family member or a professional (a lawyer, notary or tax specialist, or a trust company such as National Bank Trust).
  • The beneficiary. This person receives capital from the trust, draws an income from it, or both. They do not have any ownership rights over the trust's assets.

Responsibilities of the trustee

The role of the trustee involves a number of responsibilities. They are required to:

  • File tax returns for the trust
  • Manage its assets
  • Make annual and final reports on how the assets are liquidated
  • Manage investments
  • Carry out capital and income payments
  • Make decisions for the trust (in accordance with the powers granted in the will)

It's therefore important to make sure the person selected is able to fulfill their commitments to the trust.

What can be included in a testamentary trust?

You can put almost anything in a testamentary trust.

Some examples:

  • A house
  • A life insurance policy
  • A car collection
  • Property rights to buildings (while assigning a manager and delineating the distribution of wealth)
  • Cash amounts

Example: You might decide that income from rental property will be paid to your children when they reach a specified age or when they complete their studies.

Are taxes payable on a testamentary trust?

Trusts are taxable and there are few tax advantages. With some exceptions, income generated by a trust is taxed at the highest marginal tax rate as of the first dollar earned. This means it will be taxed at the rate applicable to the person's highest tax bracket.

Overview of marginal tax rates:

A person whose income is $100,000 will be taxed at a lower rate on the first dollar they earn than on the last. It's as if the $100,000 were divided into portions, called tax brackets. A higher tax rate applies to each successive tax bracket. In a trust, all income is taxed at the highest rate.

There used to be a number of tax benefits associated with a trust, but these have largely disappeared. There are still a few minor advantages, such as incoming splitting in certain situations.

A person whose income is $100,000 will be taxed at a lower rate on the first dollar they earn than on the last.

That said, a testamentary trust is not the best option for tax savings. It is mainly used to protect your estate and beneficiaries after your death and to ensure a smooth disbursement of the estate.

When it comes to estates and inheritance, every situation is different. Feel free to talk to your advisor. They can help you make the right choices and decide if a testamentary trust is suited to your needs.

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