Case Study 2: Death, testamentary trusts Wills & income tax
In this case study series, we examine how John and Sally’s choice of Will impacts the fortunes of their fictional family.
The purpose of these case studies is not to scare you. Our hope is to inspire you to make an informed choice about your Will, which is easy to do once you know the basics.
Nothing can minimise the pain of losing a loved one. But you don’t have to compound the problems associated with the death of a loved one by relying on the wrong type of Will.
As you will see, there is so much to gain by relying on the right type of Will.
Case Study 2: Death & Income Tax
Part 1: Meet John & Sally
Meet John, Sally and their four kids Jane 16, Toby 13, Alex 10 and Alice 6.
John 47, a public servant earns $120k per year.
Sally 44, a part-time physio earns $60k per year.
John and Sally have a family home with a mortgage, some super, about $30k cash in the bank thanks to a small inheritance to John, and Sally has also inherited $50k worth of BHP shares.
They’re not rich, but when it is all added up their combined estate (including John's one million dollar life insurance pay-out, their house and super) is worth well over two million dollars.
Part 2: John's million-dollar lifeline
Since her husband John’s tragic death (see Case Study 1), Sally’s life went into a tailspin.
As with anyone dealing with the loss of their spouse, Sally could use all the help she can get.
Thankfully, John had taken out a good amount of life insurance cover, so his estate was properly funded, even if his basic five-page Will was totally inadequate.
Part 3: Paying too much income tax
John’s life insurance has given Sally the financial space to mourn and regather herself following John’s death, as she no longer has to jump straight into full-time employment to cover John’s lost wages.
Despite John’s estate being properly funded by life insurance, John’s reliance on a basic five-page Will has left Sally unable to capitalise on this additional financial support.
Unfortunately, John’s basic Will did not provide Sally with the opportunity to leverage this inherited money from John to create a tax-effective income stream for their family.
So what’s the big deal? Sally has some financial freedom, right?
It’s true that Sally does now have some financial freedom thanks to John’s life insurance cover.
The problem is that over the next 10 years John’s basic Will costs Sally $750,000 in potential tax savings!
Part 4: John & Sally's alternate universe
Let’s now suppose John and Sally had purchased their Wills from Will Wizard.
John's Will would have allowed Sally to receive her inheritance in a testamentary trust.
As we established in Case Study 1, testamentary trusts are a special kind of trust that can only be established for beneficiaries by a comprehensive Will that includes the required testamentary trust legal provisions and trust terms.
With John's Will from Will Wizard, Sally would have been the trustee of her own testamentary trust, having full personal control over her inherited trust assets – kind of like her own personal bank she fully controls.
As trustee (or controller) of her own testamentary trust, Sally might have chosen to invest the trust assets (her inheritance).
As Sally has had time to recover from John’s death without financial burden, she hasn’t developed a drinking problem (as in Case Study 1) and instead has found a good job at a sports physio practise close to home.
As she already has a good income from this new employment, she may not wish to increase her taxable income.
Instead, Sally can choose to allocate the income earned from her invested testamentary trust assets to her three children, as is allowed under the Tax Act.
Part 5: Money better spent
This income from her testamentary trust could be used to pay for her children’s school fees and other living expenses, and the tax rate paid by Sally’s children (who are treated as tax-paying adults) would be negligible compared to Sally’s high tax rate.
Her four children would be able to receive $18,200 each year tax-free from the trust.
Part 6: Massive long-term income tax savings
Thanks to John's life insurance and super that was paid to the estate, Sally has nearly $1.5 million dollars held in her testamentary trust.
Let’s suppose a modest 5% return per annum on her invested testamentary trust wealth thanks to investing her trust funds in a low-risk diversified mutual fund.
That 5% return equates to $75,000 income per annum from the trust, most of which Sally can look to distribute among her children tax-free to pay for their living and education expenses.
Over 10 years, John’s wise decision to rely on a comprehensive testamentary trust Will from Will Wizard has saved Sally and their children around $750, 000 in income tax.
Part 7: So, what's the rub?
The conclusion from this case study is simple.
Die without a Will, or die relying on a basic 2-5 page Will and your loved ones will be paying much more income tax long-term on any income earned from their invested inheritance.
Unfortunately for Sally, over ten years this amounts to nearly $750,000 paid to the tax-man that could have been spent on her children and grandchildren.
Had John and Sally chosen to rely on a comprehensive testamentary trust Will from Will Wizard, the financial outcome, and the associated trauma would have been very different for Sally and her kids.
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As always, if you have questions about the suitability of any Will for your needs and circumstances, seek independent legal advice.