When my father passed away four years ago, he left my inheritance in the form of a testamentary trust. This means the trust did not exist while he was alive, but it was only created in his “last will and testament”, and only came into existence after his passing.
He had received some good estate planning advice, which was really for my benefit. The advantages of this trust for me were that the assets in it are protected from my creditors, they are not part of my marital property if my marriage broke up (so it would be maintained for my children) and the trust is a separate taxpayer from me.
In my case, it is the separate taxpayer status and the benefit of the graduated tax rates that provide me with the most benefit. (I don’t plan on having either creditor problems or a marriage breakdown, though I suppose people never plan for either.)
The graduated tax rate means that any interest, dividends or capital gains earned by the investments in this trust are taxed at the low tax bracket first, then the medium brackets and only at the top tax bracket if the annual investment income exceeds $135,000.
Such trusts are often used to help out surviving spouses, and provide a valuable way to continue some of the income splitting that a couple can access. This may help the widow or widower decrease taxes, avoid OAS clawback or loss of other credits provided to moderate income earners.
Whenever I have presented seminars or provided advice on this topic in the past, people often express skepticism that the Canadian tax system would actually provide this advantage for surviving family members. My answer was always, “CRA is not that generous; you have to be willing to die to get the special treatment.”
Well, it looks like the government has decided that even dying won’t be enough to merit this potential tax break. Let me explain.
In the March, 2013 Federal Budget, the government announced an intention to invite submissions from stakeholders on this issue, with a view to limiting this tax treatment, after providing a reasonable period of time for the completion of the estate administration.
UPDATE to 2015 – the negative tax changes will now take effect January 1, 2016.
At that time, a flat top rate tax will begin on the investment income earned by such trusts, after allowing up to 36 months for estate settlement through a Graduated Rate Estate regime.
The previous graduated rates for all testamentary trusts will now only apply to trusts that are created for the benefit of a disabled child.
How does this affect your own estate plan?
Changes to the tax rules that affect plans already put in place have happened in the past, and should always be contemplated in any thorough planning. Specific to this situation, writing into a new will the opportunity for testamentary trust creation may still be worthwhile, especially for non-tax reasons, but flexibility must be ensured. This is done by giving the trustees discretion to not form the trust, or wind up a trust put in place, if the tax rules change and there is no longer a benefit to the trust.
In other words, make the trust structure discretionary, with the future trustees have maximum flexibility.
There are still reasons to write testamentary trusts into a will.
1. Potential tax savings, through family income splitting. For example, if my children or grandchildren are in a lower tax bracket than me, then I can allocate the taxable income earned each year by the trust investment onto their returns, thus saving tax each year.
2. Protection of the inheritance for future generations, in the event of marital breakdown. The testamentary trust assets do not generally form part of sharable marital property, as long as kept separate.
3. Asset protection from things like creditor problems or claims. The beneficiary of the trust is the beneficial owner of the trust assets, but not the legal owner. This is true even if the same person is beneficiary and trustee.
So, existing testamentary trusts may have a continuing purpose, even though the easy tax savings are gone. There may also be a place for such trusts in the future plans of people making wills today.
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Dollars and Sense is meant as an introduction to this topic and should not in any way be construed as a replacement for personalized professional advice.Please consult legal, tax and investment experts for advice on your unique situation. David Christianson, BA, CFP, R.F.P., TEP, is a financial planner and advisor with Christianson Wealth Advisors, a Vice President with National Bank Financial Wealth Management, and author of the book Managing the Bull, A No-Nonsense Guide to Personal Finance.