≡ Menu

How Testamentary Trusts Work

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.

Final Thoughts

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.

If you would like to read more articles like this, you can sign up for my free newsletter service below (we will not spam you).

FT About the author: FT is the founder and editor of Million Dollar Journey (est. 2006). Through various financial strategies outlined on this site, he grew his net worth from $200,000 in 2006 to $1,000,000 by 2014. You can read more about him here.

{ 13 comments… add one }
  • Paul T March 5, 2012, 9:26 am

    Assuming the other spouse (Jane in the case) has a will leaving everything to the children, wouldn’t that suffice? So upon her passing, everything would be left to the children.

    Of course, wills can be changed / challenged in the future, potentially leaving the children out. So this trust setup would certainly avoid that problem.

  • FT FrugalTrader March 5, 2012, 9:52 am

    Paul, trusts are beneficial for very specific situations. The key of course is to have a will in the first place. Personally, I think the main benefit is for high net worth people to leave their wealth for the next generation while having an efficient tax structure.

  • Paul T March 5, 2012, 10:01 am

    FT: The deemed disposition after 21 years doesn’t sound too appealing. Sort of like kicking the can down the road on the tax hit.

    At the event, did they give you any idea what the minimums are to make this worthwhile?

  • FT FrugalTrader March 5, 2012, 10:12 am

    I think the best bet is to look at tax savings. Say that you leave a after tax/probate etc $1M portfolio for the next generation that distributes $40k in interest per year. If the adult child is in the top tax bracket making $135k/yr, he/she would pay ~46% tax (~$18k). If the portfolio was placed in testamentary trust, the interest would only face 24% tax ($9,600). In this specific case, the tax expense is cut in half.

  • FT FrugalTrader March 5, 2012, 10:33 am

    Another thing to note is that testamentary trusts are not eligible for tax credits except for the dividend tax credit and the donation tax credit. Basic personal amount is non eligible.

  • Patricia March 5, 2012, 12:03 pm

    I am in the final stages of changing my will to set up two testamentary trusts, one for each of my adult children. One child is absolutely not interested in financial management, the other has had a business collapse in this economy, and his marriage ended under all the stress, too. Besides all the benefits you mention, a testamentary trust protects the assets in it from creditors, legal actions, ex-spouses, etc. Plus, the MER for managing its assets by the trustee I’ve named starts at 1.5% and goes down from there depending on the total value. I haven’t put any restrictions on what can be withdrawn from it or when. Anyone with a home that is paid off or life insured could be leaving a substantial estate.

  • FT FrugalTrader March 5, 2012, 12:12 pm

    Thanks for the info about some of the costs. Is the fee you mentioned by a professional agency? Did you do any comparison shopping before committing?

  • Patricia March 5, 2012, 12:24 pm

    Yes, I did comparisons between two big banks. I went with Scotia Bank’s affiliated trust company Scotia Private Client Group. Not only is their MER good, but they provided some great financial analysis AND they worked with me to look at all angles of my will then they drafted instructions for my new will which I approved and sent to a lawyer. I figure this alone saved me a few hundred in lawyers fees. They will review my will at least once per year or at my request. And they monitor tax changes that could affect me and will advise me accordingly. Plus there is no obligation to continue with them; I can change my trust company or forgo a trust company altogether. I have paid nothing for these services.

  • Joe March 5, 2012, 2:13 pm

    Good article about an interesting tax-efficient estate planning tactic; nothing to add so I wanted to throw in this Public Service Announcement:

    A will and term life insurance. These are the two key pieces of ‘estate planning’ that the average Canadian will need. Yet a frightening percentage of Canadians die intestate and indebted. It’s the cheapest/easiest that it’s ever been to get a will and affordable term coverage. Please don’t be a statistic.

  • Fit March 6, 2012, 4:19 pm

    Jamie Golombek is amazing, take a look at his site and absorb as much info as possible. Creating first generation wealth is tough enough. Transferring it to the next generation is always interesting. When it comes down to it though life insurance is always one of the most cost effective ways to do this. Term insurance is amazing… especially if it is convertible to permanent insurance in the future as you never know if you will qualify for it down the road and you may need to convert it haha who knows

  • Greg March 9, 2012, 11:04 am

    Thanks for the intro. If possible, could you go into some detail about what happens when the person testator passes away: what steps would the executor go through, who would she deal with, and how exactly would the trust be set up when the time comes.

    Thank you.

  • FT FrugalTrader March 9, 2012, 1:18 pm

    @Greg, those details are best left to the professionals as I’m sure they differ for every province. Maybe you can contact one of the big banks for a consult? A reader above recommended the Scotia Private Client Group.

  • James April 24, 2014, 2:50 am

    Great Article. I am a Financial Planner for a large FI. Patricia..there is no free lunch. I used to work for Scotia, they would only review your will if they are deemed to be corporate executor. They charge between 3.5-5% of probate assets for this service once you pass away. I only recommend this to clients in certain situations.

    For example:

    1) No beneficiaries in Canada (Or at least not close)
    2) Fighting in the family
    3) Complex estate planning issues

    If you sit with the right planner, ie a CFP, they can give you this information.

Leave a Comment