A little while ago, I was invited to a local CIBC event that featured a presentation by Jamie Golombek. For those of you who haven’t heard of Mr. Golombek, he’s the Managing Director, Tax and Estate Planning for CIBC, and regularly publishes tax articles for the Financial Post. I was a fan of Mr. Golombek even before the presentation, but the talk confirmed my impression that when it comes to tax, he really knows what he is talking about.
Since the presentation was geared towards wealthy investors (I was invited as a +1 by a wealthy investor), most of the presentation revolved around estate planning and leaving a legacy for the next generation. One topic that really caught my interest was the use of a testamentary trust to help preserve wealth upon passing. The example that really sold me was of the wealthy couple, breadwinner John and domestic coordinator Jane who had young children. John sadly passes away and leaves all assets to Jane. After some time, Jane falls in love again and marries Bob. If Jane were to pass away, then the wealth that John spent his life building could potentially be left to Bob and not John’s children. This problem can be solved by setting up a testamentary trust.
What is a Testamentary Trust?
Testamentary trusts are different than other trusts where its created as part of a will and becomes enforced once the trust creator (or testator) passes. As well, unlike other trust arrangements, income or gains within a testamentary trust faces graduated tax rates like a regular individual, but, like other trusts, has to file an annual tax return. The graduated tax rate advantage can have many tax planning possibilities, especially where the beneficiaries are already in the top marginal tax bracket.
Update Federal Budget 2014: Graduated tax rates are now limited to the first three years of the trust. After that, taxation is at the highest tax bracket.
When Should a Testamentary Trust be Considered?
As mentioned, testamentary trusts are a separate entity with a designated beneficiary (or beneficiaries). If the assets to be left behind are considerable, this setup can be an advantage in scenarios like:
When you want to leave money to adult children in higher tax brackets.
It’s fairly common for wealthy parents to raise successful children. If the children are highly paid adults by the time the testator passes away, keeping assets in a testamentary trust may make sense from a tax perspective. Since the testamentary trust has the benefit of graduated tax rates, it will pay lower overall taxes than if the money was taxed at the highest marginal rate with the adult children. With this kind of trust, the beneficiaries have the option of flowing through money from the trust, or simply keeping it within the trust.
Preserve estate if spouse remarries
As per the example with John and Jane, I’m sure that John wouldn’t want his estate going to someone that he doesn’t even know, especially the possibility of his children getting nothing. A spousal testamentary trust can be setup with Jane as the beneficiary which will remain as a separate entity even if Jane remarries. Jane could then setup trusts for her children in case she were to pass, this can be especially helpful in blended family situations.
Leave money for child, but not until a certain age.
Another common usage and advantage of trusts is that the testator can control when the funds are distributed to the beneficiaries. This situation may be beneficial when a wealthy family has a child who is spendthrift in the hopes that age helps the adult child become more financially responsible.
The Downside of Testamentary Trusts
As with most financial accounts, there are some drawbacks as well. The most apparent ones are:
- 21 year deemed disposition rule – This rule will force a deemed disposition, thus tax liability, of assets with the testamentary trust 21 years after the trust is activated. I’ve heard of strategies to reduce this burden, like active trading, but a professional will need to be consulted.
- Extra Costs – There is an added cost to setting up a will with a testamentary trust. Not only that, an accountant needs to be paid to file income tax for the trust annually, and there is usually a fee paid to the trustee who is in charge of administering the trust.
Altogether, I think that testamentary trusts can be a powerful tool, especially for the high net worth families who plan to leave a legacy for the next generation. What are your thoughts on testamentary trusts? If you know more details about them, please share.