KEY TAKEAWAYS

  • A testamentary trust is a type of trust created by will and executed when the grantor dies.

  • A testamentary trust has to pass through probate.

  • The assets of a testamentary trust can be distributed over time, when a beneficiary reaches a certain age, or when a certain condition is met.

An Overview of Testamentary Trusts and Their Benefits

A testamentary trust is a type of trust created out of someone’s last will and testament. It takes effect when the grantor passes away and is executed according to state law. This type of trust aims to manage and distribute the grantor’s assets according to the terms of the will. Since the assets must be distributed over time, it can be an excellent tool for wealth management.

What is a Testamentary Trust?

Define Testamentary Trust

A testamentary trust is a powerful estate planning tool that ensures a person's assets are managed and distributed according to their wishes after they pass away. This kind of trust is a legal arrangement where assets are placed in trust and managed by a trustee to benefit specific beneficiaries. The trust is executed according to the terms outlined by the grantor. The assets in a testamentary trust can be cash, property, stocks, or other investments. The trustee manages these assets and makes decisions based on the grantor's wishes. This ensures the grantor's intentions are followed after they pass away. The trustee also pays taxes and fees related to the trust.

Key Uses for Testamentary Trusts

The trust often provides for children, dependents with special needs, and charities. It ensures a gradual distribution of assets rather than lump sums. A notable example of a testamentary trust was the one created by the late singer Whitney Houston to benefit her now-late daughter, Bobbi Kristina. Bobbi Kristina was set to inherit 10% of the trust assets at age 21, another one-sixth of the trust assets at age 25, and the remainder at age 30. Since Bobbi Kristina did not live to receive the bulk of her inheritance, the remaining assets were distributed to Houston’s brothers and mother.

How Does a Testamentary Trust Work?

A testamentary trust serves as a lasting safeguard to ensure that a person's legacy is protected and their assets are carefully managed and distributed exactly as they envisioned after their passing. The trust is typically executed  in the following order:

  • Activated Upon Death: Testamentary trusts are created through a will and only become active after the grantor passes away, and the will goes through probate.

  • Court Supervision: Since the trust is part of the probate process, it is subject to court oversight, ensuring the trustee follows the terms of the trust.

  • Trustee Management: A trustee is designated in the will and is responsible for managing the assets according to the grantor’s wishes, typically until the beneficiaries meet specified conditions (e.g., reaching a certain age). However, before the trustee assumes their duties, they must undergo certification. 

  • Asset Distribution: The trust holds and distributes assets according to the instructions in the will, often focusing on long-term financial support for beneficiaries like minors or dependents.

Consulting with a lawyer is advisable if you want to set up a testamentary trust.

Advantages and Disadvantages of a Testamentary Trust

There are many advantages to creating a testamentary trust. Let’s take a look at a few.

Advantages 

Disadvantages 

It gives detailed instructions for distributing assets, especially to minors or dependents. It ensures long-term management.

A testamentary trust is set up by a will, so it must go through probate, which causes delays and costs.

The trust terms can be updated if the will is changed before death, making the trust very flexible.

Once created, a testamentary trust is hard to amend or revoke. This limits its ability to adapt to changes in circumstances.

Court supervision can help ensure the trustee follows the trust's terms.

Beneficiaries may have to wait until probate is complete to receive their assets.

Testamentary Trust vs. Living Trust

Key Differences in Structure and Activation

A living trust and a testamentary trust differ in timing and structure. The grantor establishes a living trust that becomes active during their lifetime. This allows them to manage and transfer assets while they are still alive. It can help avoid probate, providing privacy and quicker asset distribution. A testamentary trust is only activated upon the grantor’s death. It is created through the will and must go through probate before the trustee can manage and distribute assets. This ties the testamentary trust more to the court system. However, it is more cost-efficient during the grantor's life since it needs no upkeep.

Which Should You Choose?

Deciding between a testamentary trust and a living trust requires careful estate planning. Testamentary trusts are often preferable when the beneficiaries are minor or disabled children. With this type of trust, the grantor can set the age for asset distribution and the frequency of payments. Since testamentary trusts have to pass through probate, there is an extra layer of protection to ensure the right amount of money lands in the right hands. 

On the other hand, a living trust(inter vivos trust) does not have to pass through probate. This type of trust lets the grantor control assets during their life and distributes them upon their death, avoiding probate delays and costs. Living trusts are often preferred. They offer more flexibility, privacy, and control over one's estate and avoid probate. However, this requires more management, which makes it less cost-effective than a testamentary trust.

Testamentary Trust vs. Revocable Trust

Key Differences in Flexibility and Control

A revocable trust is a type of trust that can be altered, amended, or completely revoked while the grantor is alive. The grantor retains complete control over the assets in the trust while alive and mentally competent, offering a great deal of flexibility. A  living trust is a type of revocable trust. 

On the other hand, a testamentary trust is less flexible than a revocable trust. Since this type of trust takes effect after the owner dies, it cannot be amended or revoked. 

When to Use Each Trust Type

Revocable trusts offer a great deal of privacy since they do not have to pass through the court. This allows the grantor to execute the trust without the public knowing. The grantor is also free to change the terms of the trust at any time. This type of trust is ideal for those who want flexibility in managing their estate or adapting to changing life circumstances, such as marriage, divorce, or children's birth.

In contrast, a testamentary trust is best for a grantor focused on end-of-life planning. Since it does not take effect until the grantor's death, it is less costly to administer during the grantor’s life and helps ensure that their final wishes are fulfilled. 

Legal and Tax Implications of Testamentary Trusts

Once activated, a testamentary trust is a separate legal entity for tax purposes. The trust must obtain its Tax Identification Number and file IRS Form 1041. Any income from the trust's assets is generally taxable. The trustee can either distribute this income to the beneficiaries or keep it in the trust.

Beneficiaries will usually report and pay the  tax on this income at their tax rates. If the trust keeps the income, the trust will pay taxes at its higher tax rate.

The assets in the testamentary trust are subject to estate tax as part of the decedent’s estate. However, once the assets are in the trust, they will no longer be subject to estate taxes.

Any realized capital gains are subject to capital gains tax if trust assets are sold. Beneficiaries who receive these gains may need to report them on their returns.

Frequently Asked Questions (FAQs)

Is money from a testamentary trust taxable?

Yes, a testamentary trust's distributions can be taxable. It depends on the income's nature. If the trust retains its earnings, they are taxable to it. If the beneficiaries receive them, they must pay taxes on the funds. However, if the principal is distributed, the beneficiaries do not have to pay taxes on it.

What is the benefit of a testamentary trust?

A testamentary trust controls how assets are distributed. It ensures beneficiaries receive funds according to the grantor's wishes, which is especially helpful for minors or dependents. The trust also protects assets from creditors, divorce, and bad decisions. 

What is the biggest risk inherent in the proposed testamentary trust?

The biggest risk of a testamentary trust is its reliance on probate. This can cause delays and added costs before the trust becomes active.