Is a testamentary trust right for your estate plan?

If you’ve decided to pass on your wealth, you’ll not only be faced with a decision of who should receive it—children, charities, friends, siblings, etc.—but also the dilemma of the best way to transfer those assets, in what amounts and when.

Regardless of who will be your beneficiary, you don’t want to be faced with a worst-case-scenario. For example, if parents pass away while their kids are still young. How can and should their assets be distributed, presumably over the long term? Or, parents may want to avoid giving spendthrift adult children all of their money at once after they die. What should they do?

What is a trust?

One of the most effective ways to control how wealth is distributed is by setting up a trust. A trust is a relationship between three parties: the settlor or testator (the person establishing the trust); the trustee and the beneficiaries.

Essentially, the trustee is responsible for administering the trust assets for the benefit of the beneficiaries. There are two types of trust: inter vivos or living trusts set up during a person’s lifetime and testamentary trusts, which take effect after a person’s death.

Here we’re looking at testamentary trusts as a strategy for individuals to pass along wealth to family members or other beneficiaries:

Testamentary trusts: A potentially wise estate-planning move

Because a testamentary trust comes into effect when a person dies, the terms of the trust are established in a Will or through a separate trust document.

The Will should document the assets to be held in the trust, the beneficiaries, the trustee and what their powers will be, as well as, the duration of the trust and how distributions will be made.

“A trust enables you to maintain a degree of control over transferred assets, by setting out who gets the benefit of what and over what period of time,” says Tracey Woo, director of the professional practice group at RBC Wealth Management’s Royal Trust division.

“In many circumstances, having the protection of a trust makes for good estate planning.”

Who could benefit the most from a testamentary trust?

Testamentary trusts are particularly useful for people with blended families, spendthrift heirs or beneficiaries with disabilities, Woo says, because of how they can control and restrict the distribution of assets.

For example, with a blended family, a trust could lay out that a second spouse can continue to receive benefits from an estate until he or she dies and on his or her death, the capital of the trust is to be distributed among the testator’s children from a prior marriage.

“You can be very creative with trusts,” says Elaine Blades, senior manager of the professional practice group at Royal Trust.

Properly structured, trusts can also protect assets from potential creditors or matrimonial claims.

“That’s often a big concern for parents – that their asset—in particular special assets such as a family business or cottage—go to their kids and not their spouses in the event of a divorce,” says Blades. “Establishing a trust allows you to put in some extra protection.”

Testamentary trusts are also a good tool for anyone who has a child with a disability. Individuals can set up a Qualified Disability Trust (QDT) for the benefit of a disabled child in their Will, which also has some tax advantages, and can ensure the child has financial security in the future.

In order for a trust to qualify as a QDT under the Income Tax Act, there must be at least one beneficiary of the trust who receives the federal disability tax credit and elects to treat the trust as a QDT.

In addition to allowing them to benefit from the growth of assets, you get the benefit of graduated rate taxation in that trust, Woo says. Graduated rates for other types of testamentary trusts were eliminated by the federal government in January, 2016 and are now taxed at the highest marginal rate.

While trusts are highly recommended to protect and control assets, there are some drawbacks to be aware of beforehand.

Trusts can be complex and time consuming to establish and run. Individuals are advised to seek professional legal and tax advice.

“It comes down to the cost-benefit analysis, which you do need to weigh,” says Blades.

Finding the right trustee

Picking a trustee to help transfer the estate is key, says Woo. You can name an individual to the role, or choose a trust company.

Woo says people should be careful about who they appoint given that the job is complex, time consuming.

In some circumstances it may not be wise to choose a family member, Woo says.

“You’re putting a lot of trust in them and hope they fulfill all of the duties and obligations you set out in your trust agreement,” Woo says. “ It’s not a responsibility to be taken lightly.”

It’s why many people opt for a third-party trust company to handle their trust, Blades says.

“Depending on the situation, there may be an individual who is appropriate, but quite often an independent, objective, third-party trust company that’s always going to be there—for some people that’s the better choice,” she says.

Testamentary trust takeaway

Professionals are less likely than business owners to have a comprehensive wealth transfer plan in place, according to the RBC Wealth Transfer Report. The report says 39 percent of business owners have a full wealth transfer plan, compared to just 26 percent of employed professionals, underscoring the need for more Canadians to develop a comprehensive estate plan.

People cannot and should not assume their financial legacy will carry on the way they intended unless they lay it out in structures like a testamentary trust.

What’s more, a proper estate plan provides peace of mind today that assets will be distributed the way a person intended in the future.