What is a Testamentary Discretionary Trust?

A Testamentary Discretionary Trust (‘TDT') is a trust created by a Will that only comes into existence when the Will Maker dies.

If a Will Maker establishes a TDT for the residue of their estate, then after any specific gifts and estate debts have been dealt with, the balance of the estate forms the TDT. The TDT can contain all types of assets including residential property, cash and other income producing assets such as shares and investment properties.

The Trustee, the terms of the trust and powers of the Trustee are set out in the Will. The Trustee usually has full discretion to determine amounts and timing of distributions of income and capital to any one or more of a range of beneficiaries named and trust assets cannot be accessed by any of the potential beneficiaries without the Trustee first exercising its discretion to distribute assets to them. The Trustee is often the same person at the Executor and can also be a beneficiary.

A TDT can operate for up to 80 years but the Trustee often has the power to wind up the trust at any time prior to that.

A TDT is often best used in circumstances such as the following:

· To minimise income tax and capital gains tax;

· To protect spendthrift beneficiaries from themselves;

· To protect an inheritance from a beneficiary's former spouse;

· To protect an inheritance from a beneficiary's creditors; and

· To protect a beneficiary's pension eligibility.

A TDT can offer the above protection and tax minimisation because the control of the trust is separated from ownership of trust assets. This control can be held by a beneficiary, usually the surviving spouse or an adult child.

How a TDT minimises tax

By including a broad range of potential beneficiaries for the TDT, under current taxation laws the Trustee of the trust can distribute trust income tax effectively. The Trustee decides the amounts to be distributed, the timing of the distributions and to whom income is distributed.

Unlike a family trust which you may establish during your lifetime, income distributed through a TDT to a beneficiary under the age of 18 can have a significant tax savings because minors are assessed at ordinary marginal rates and not at the penalty rates normally applicable to minors. The ordinary marginal rate applied here means each child has a full tax free threshold of $11,000 (including the low income rebate of $750), in relation to any trust income derived from a TDT applied for their benefit.

The following example illustrates the benefit of tax savings in a TDT. Assume that:

· John and Susan have one son, Jack,

· Jack has three children all under 18 years,

· Jack earns $100,000 income per annum,

· Jack receives an inheritance from the survivor of his parents of $600,000.

If Jack does not use a TDT

Income Source Jack

Salary Income $100,000

Inherited Income $ 30,000

Taxable Income $130,000

Tax payable $ 41,050

Net Income $ 88,950

If Jack uses a TDT (assume the trust generates net income of 5%, say $30,000 yearly)

Income Source Jack Child 1 Child 2 Child 3

Salary Income $100,000

Inherited Income $10,000 $10,000 $10,000

Taxable Income $100,000 $10,000 $10,000 $10,000

Tax Payable $ 28,600 $0 $0 $0

Net Income $71,400 $10,000 $10,000 $10,000

The above calculations are based on 2007/08 tax rates and include the medicare levy.

NB: tax rates may change from year to year hence the above tax calculations may vary.

If Jack receives his inheritance outright he pays $41,050 income tax, but if he receives his inheritance via a TDT, splitting the income between his children for their maintenance and education, he pays $28,600 income tax, saving $12,450 yearly.

How a TDT protects inheritances from a former spouse/Trustee in bankruptcy

Another advantage is that the assets owned by the trust are protected. They cannot be accessed by any of the potential beneficiaries without the Trustee first exercising the discretion to distribute the assets to them. Therefore, in the event of divorce or bankruptcy of one of the beneficiaries, it will be more difficult for their former spouses and creditors to attack the assets held in trust.

This may be advantageous if one of your beneficiaries is in a high risk profession where they may be exposed to potential negligence claims or where they may be carrying on a business.

It also may be advantageous if one of your beneficiaries is in an unstable relationship or where a divorce or relationship breakdown and therefore property settlement may be likely. The assets in the trust cannot be divided between the couple as the use of the trust separates the assets held in the trust from the assets owned by the couple in their own names, effectively ‘quarantining' the assets in the trust.

The Author

Tim James is an Estate Planning Solicitor with McDonald Pynt Lawyers and he has extensive experience in Estate Planning as the former Head of Estate Planning with the Commonwealth Bank of Australia and as Manager Estate Planning with the National Australia Trustees. Tim offers an initial free consultation with and will give a fixed quote for preparation of documents and can be contacted on 9335-7171.