How you can protect your children’s inheritance

Most lawyers can prepare a standard will, or simple will as they are commonly known, but few lawyers possess the necessary skill to draft advanced wills, or testamentary trust wills, as they are technically known.

In simple terms the difference between a standard will and an advanced will is that with a standard will your children receive their inheritance in their own personal name, whereas with an advanced will your children have the option to receive their inheritance via a trust that is set up by the will.

Advanced wills have grown in popularity because it is favourable for your children to receive their inheritance via a trust instead of in their own personal name.

To summarise there are three main benefits that advanced wills offer (assuming your children elect to receive their inheritance via the trust and not in their own personal name):

1. Ability to separate control

Advanced wills can be used to protect children beneficiaries that are minors or reckless spenders.  For instance, if you have minor children you may wish for your children to take control of their inheritance at say 25 years of age instead of 18 years of age, which is the default position under a standard will.  Clients often do this because it is generally accepted that 18-year olds are not well equipped to make sensible decisions regarding how their inheritance should be invested.  In this scenario if you were to pass before your children reached say 25 years of age, you could appoint a trustee to manage your children’s inheritance on their behalf until they reach the specified age.

2. Asset protection benefits

By leaving your estate to your children via an advanced will their inheritance is protected even if they become bankrupt in the future.  This is not the case if your children receive their inheritance via a standard will. Also, by leaving your estate to your children via an advanced will, it is more difficult for your children’s future spouses (or de facto partners) to get their hands on your children’s inheritance should a relationship end following your death

For example:

Jessica and her husband enjoy buying and renovating properties then selling them for a profit.  Jessica inherited $1,000,000 from her mother 2 years ago via an advanced will.  Jessica opted to receive the inheritance via a trust and choose to invest the funds in Australian shares and fixed interest investments. Jessica and her husband purchased a block of units for $3,000,000 shortly after Jessica’s mother passed away.  Since this time zoning laws have changed meaning Jessica and her husband can no longer sell the units individually as they had planned.  This has dramatically affected the price of the units which are now valued at $2,000,000.  On top of all this, Jessica’s husband was made redundant 6 months ago and is struggling to find a new job.

As Jessica’s husband was the bread winner for the family, Jessica and her husband have struggled to pay their living expenses let alone meet the interest repayments for the units.  As a result, their bank exercised its right as mortgagee and sold the units for $1,300,000 at a fire sale auction.  The bank has since taken action to sue Jessica and her husband for the remainder owing which is $1,500,000 (noting a $200,000 deposit was used to purchase the units).

Apart from the $1,000,000 inherited by Jessica from her mother, Jessica and her husband have only $50,000 of assets.  Jessica’s accountant advises Jessica and her husband to file for bankruptcy.  They follow the accountant’s advice and hand over their remaining $50,000 to the bank, meaning there is still $1,450,000 in outstanding debt.  What happens to Jessica’s $1,000,000 inheritance?

If Jessica received the $1,000,000 from her mother via a standard Will, the funds would be in her own personal name.  This means the $1,000,000 would also be forfeited to the bank to go toward paying the $1,450,000 debt.  The situation would be different if Jessica received her inheritance via an advanced will, this is because the funds would be held by the trust and not in her own personal name (assuming Jessica did not remove the funds from the trust).  The end result would be that Jessica and her husband would be made bankrupt and Jessica would be permitted to keep the $1,000,000 inheritance.

3. Tax minimisation strategy

The main reason why advanced wills have grown in popularity is because they are tax effective.  The following worked example provides a simple illustration how an advanced will could be used by your children to reduce their tax bill:

Samantha receives an income that places her in the top marginal tax bracket of 49% (includes 2% deficit repair levy).  She has 3 children with her husband – aged 2, 4 and 6.

Samantha is about to inherit a $650,000 apartment from her recently deceased father.  The apartment is rented out for $45,000 per annum.

In the following scenarios we illustrate how an advanced will can be used by beneficiaries to minimise tax by utilising a strategy called income splitting.

Scenario 1: Samantha inherits via a Standard Will

If Samantha inherits the apartment via a standard will she will pay tax on the rent received in accordance with her personal income tax rate.  The tax payable is calculated as follows:

Gross income                                              $45,000

Tax on $45,000                                          $22,050          (@ 49% tax)

Net income                                $22,950

So of the $45,000 gross annual income received by Samantha, $22,050 will be paid as tax meaning the net annual income will be $22,950.

Scenario 2: Samantha inherits via an Advanced Will

Let us compare the outcome where Samantha inherited the apartment (or any other asset for that matter) via a trust set up by an advanced will.

Under current taxation laws, Samantha can allocate the trust’s income to her three children as she chooses.  The taxable income for each child is as follows:

Gross income                                              $45,000

Tax on $15,000 (Child 1)                         $       Nil          (Within tax free threshold)

Tax on $15,000 (Child 2)                         $       Nil          (Within tax free threshold)

Tax on $15,000 (Child 3)                         $       Nil          (Within tax free threshold)

Net income                                $45,000

By ‘splitting’ the income received between her three minor children, Samantha can take advantage of her children’s tax free thresholds.  In summary, no tax is paid on the $45,000 rent received, meaning the after-tax cash saving for Samantha is $22,050 and the net annual income is $45,000 for the relevant financial year.

If prepared correctly, your advanced will can offer significant benefits to your children. Look out for lawyers that practice exclusively in wills and estates and have significant experience in preparing advanced wills or wills with testamentary trusts as they are technically known.