Estate planning: testamentary trusts and child pensions explained

Providing for the next generation is a key concern for many clients. Mark Gleeson takes a look at core testamentary trusts and child pensions.

Estate planning is a critical part of holistic financial planning, but it is usually only covered briefly in a statement of advice.

However, there are opportunities to assist clients with estate planning and to build the advice into the plan fee.

This article compares two strategies when planning super death benefits for the next generation: testamentary trusts and child pensions. Choosing the right option is particularly important when insurance cover is placed within super.

Lack of planning can remove options that provide tax effectiveness and control for your client.

Testamentary trusts

A testamentary trust is set up by an appropriate clause in the will and is activated following the client’s death using estate assets.

Testamentary trusts are generally discretionary and offer flexibility. The trustee can vary the income distributions each year depending on the beneficiaries’ circumstances.

This can generate tax savings, since minors pay tax on income received at normal marginal tax rates rather than prescribed rates.

Assets held in a testamentary trust may be protected from bankruptcy, relationship breakdowns and children who are not financially responsible.

A testamentary trust can be used to provide greater control over the distribution of estate assets. The trustee retains full control over the capital while the trust exists, based on the testamentary wishes of the deceased.

Capital distributions can be made over time to meet the child’s future needs.

A beneficiary may only become entitled to a capital distribution upon attaining a certain age. Alternatively, amounts could be staggered to provide distributions at certain ages — for example, age 18 and 25.

Payments such as super death benefits and insurance proceeds can be directed into a testamentary trust via the estate.

Consequently, the estate must be nominated as the beneficiary of the super fund. If there are non-tax dependant beneficiaries of the testamentary trust, the executor must withhold any tax on the super lump sum.

Two disadvantages exist with testamentary trusts:

• the estate may be delayed until grant of probate is completed. This further delays establishing the trust; and
• the estate may be contested, so the trust may have reduced assets available for beneficiaries.

Child pensions

A child pension is an income stream payable to a child following the death of the client. This option may be available when your client dies and has super available, including any attached life insurance proceeds. A child can receive a death benefit pension if they (upon the client’s death):

• are under age 18;
• are aged at least 18 and under 25 and financially dependent of the deceased; or
• have a qualifying disability.

A minor is generally prevented from operating the pension account. Accordingly, a surviving parent or guardian is generally authorised by the trustee to transact on behalf of a minor.

The trustee may impose restrictions on certain transactions if they are not considered in the best interests of the minor.

Once aged 18, ownership generally passes to the child and they can then access all the capital.

This may concern your client if they do not want their child potentially gaining access to tens or hundreds of thousands of dollars at age 18. Whether a child pension option is suitable depends on the level of control desired by the client within the estate plan.

A child pension is very tax-effective. Earnings within the pension are tax-exempt. Pension payments are taxed in the recipient’s name based on the age of the deceased and recipient.

Where the parent (and child) are under age 60, the tax-free component is received tax-free and the taxable component (element taxed) is taxable but receives a 15 per cent tax offset. If the parent has reached age 60, the payments are tax-free.

The child pension must be paid out as a tax-free lump sum by age 25 (unless the child has a qualifying disability). Cashing the entire benefit before age 25 is tax-free. Partial withdrawals are not permitted (unless disabled).

To ensure a child pension is established upon your client’s death, the child must be nominated as the beneficiary.

Failing to nominate a child beneficiary may remove the child pension option, as the trustee could pay another dependant or the estate.

Not all superannuation funds offer child pensions, so you should check with the product provider

Case study

Matthew is 42, single and has two children aged seven and nine. He has $150,000 in super (taxable component) and $1.35 million insurance cover. He wants to identify how to provide financially for his children if he dies.

Let’s assume $500,000 is taken as a lump sum and used to repay the mortgage and funeral expenses. The remaining $1 million could be paid into a testamentary trust or child pensions.

The choice depends on Matthew’s estate planning wishes. The table compares the tax and control aspects.

A testamentary trust provides greater estate planning control for Matthew, but is generally less tax-effective. The child pension option provides less control, but is generally more tax-effective. This general trade-off is illustrated above.

A combination of the two options could also be used.

You should also consider the age of the child. The younger the child, the more advantageous the child pension may become as the account balance can be reduced over time with pension payments.

Consequently, the risk of a large amount remaining at age 18 reduces.

The closer the child is to age 18, the more advantageous the testamentary trust may become as capital can be controlled more effectively.

Estate planning aims to transfer the right asset to the right person at the right time following death. You must identify the appropriate option for your client’s estate plan.

Both testamentary trusts and child pensions are options available to help support your client’s family following their death.

Planning must occur now rather than following death. It is crucial to ensure nominations of super funds are updated to reflect the estate plan. Ongoing review is required as your client’s circumstances change.

Mark Gleeson is technical services manager at ING Australia.