A key quality of trusts is that the Income Tax Act treats them as a separate individual taxpayer. A second key characteristic is that testamentary trusts benefit from the graduated personal income tax brackets, whereby lower income pays tax at a lower rate. A third important feature is that assets in a trust, while they are there, legally belong to the trustee and not the beneficiary.
What are the six reasons that people should consider using a testamentary trust?
- Tax Savings from Income Splitting for Children and/or Grandchildren - consider a grandparent who wants to leave money for minor children - instead of leaving everything to the parents who then must include the income it generates in their own income, which may be at a high rate already, the inheritance is put into a testamentary trust. Minor children are likely to have little or no other income, so the trust distributes income to the children who pay no tax. The inheritance can perhaps provide tax-free income for many years. If the parent is named as trustee, and the instructions in the will give the discretion, he/she can still control all the spending on behalf of the children. Each child can have a trust, further sub-dividing the income. For an adult child with a high income already, the trust may be in a lower tax bracket so it could retain the income to be taxed instead of distributing it to the child. A properly set up trust can have the ability to change from year to year whether it distributes any, some or all income, so that overall taxes are minimized.
- Tax Savings from Income Splitting for a Spouse - in a similar manner as for children, sending an inheritance into a trust that has discretion whether to pay out income or retain it in the trust and have it taxed there may reduce overall taxes and allow the spouse to keep income tested OAS payments. That does not prevent the withdrawal of capital from the trust for money to spend.
- Protection of Funds for Disabled or Spendthrift Beneficiaries - for people not capable of managing an inheritance, especially when it has to last and support someone who cannot go to work and earn a living, a trust can be very beneficial; in addition, since a trust is a separate legal entity, creditors cannot come after funds held in a trust for a bankrupt person
- Protection of Funds from a Spouse of a Beneficiary - this could be a child in a shaky marriage, or a widow(er) in a second marriage; since the trust owns the assets, the other spouse can be prevented from laying claim
- Avoidance of Probate a Second time and Capital Gains Deferral through Rollover to a Spousal Testamentary Trust - tax rules allow a spouse, and only a spouse, to receive inherited assets exempt from the usual rules whereby capital property is deemed to have been disposed of at death at fair market value and capital gains tax has to be paid. This can allow capital gains to be spread over time, reducing taxes and to be deferred, allowing greater growth. When the assets are eventually distributed by the trust, they do not pay probate a second time as they do not pass through the will of the spouse.
- Control of the Funds - the trust can be set up so that children receive the capital to spend as they wish only when they are older, and hopefully wiser, or only for specific purposes; meantime a trustee, perhaps a parent, can decide what the trust will disburse. The trust can also mandate that income is used to support a spouse till death, after which any remaining assets are given to someone else, perhaps grandchildren or a charity.
- administration cost / trustee fees if done by a company or third party professional; in my view, a professional trustee is not necessary for many if not most circumstances; it can be quite straightforward, I've done it
- extra tax returns and record-keeping: the trust must file a return every year even if it is only to report that it is distributing all its income to the beneficiaries. Though a trust can pick any date for its year end, if you are going to manage it yourself and use a discount broker to hold the assets in an account, the broker will only send out forms based on the calendar year, so you have to do a lot of manual work adding up the revenues
- limited choice of discount brokers for investments in a testamentary trust: when I decided to manage the investments myself and approached various brokers, some said they did not handle trusts and others did not even know what a testamentary trust is. There was a presumption that you should deal with the full service broker side of their business.
More detailed reading:
Richard White, Advantages of establishing a testamentary trust at the Ontario Medical Association - child income splitting example
Thompson Dorfman Sweatman, The Tax Planned Will - Creating Savings for Your Spouse and the Next Generation - OAS example
Richard S. Niedermayer, Testamentary Trusts, at ProfessionalReferrals.ca
Kenneth C. Pope, Trusts - give examples of set up and professional management fees
Glenn C. Davis, Spousal trusts Protect Assets, Income and Heirs at SunLife Financial
Green Financial Group, Tax Planning with Testamentary Trusts - good income splitting for spouse tax saving example