What is a Testamentary Trust and How to Tax-Effectively Distribute an Inheritance

Leaving an inheritance is one thing. Making sure your family can keep more of it is another.

An inheritance left directly to a beneficiary can become exposed to tax, relationship breakdowns, creditors, poor financial decisions, or other risks you may not have anticipated. A testamentary trust can provide another way to pass on wealth, giving your beneficiaries greater flexibility over how an inheritance is held, protected and distributed.

For some families, one of the biggest attractions is tax. When structured and used appropriately, a testamentary trust can create opportunities to distribute investment income among eligible beneficiaries in a more tax-effective way, including potentially significant advantages when distributions are made to minors.

But those benefits come with additional complexity and ongoing responsibilities. So, when is a testamentary trust worthwhile?

This article explains how testamentary trusts work, the protections they can offer, and the tax considerations that can make them valuable, so you can have a more informed conversation with your solicitor, accountant or one of our financial advisers about whether one belongs in your estate plan.

 

What is a testamentary trust?

A testamentary trust is a trust created within your will that comes into effect after your death. Unlike a standard bequest, which transfers assets directly to a beneficiary, a testamentary trust holds and manages those assets for the benefit of nominated beneficiaries over time.

It is managed by a trustee; someone you appoint within the will. The trustee has discretion over how and when income and capital are distributed to beneficiaries. This discretion is central to both the protective and tax advantages the structure offers.

Importantly, a testamentary trust is not the same as a family discretionary trust set up during your lifetime. The ATO treats them differently, and assets cannot simply be directed into an existing family trust via a will to achieve the same result. The trust must be established specifically within the will and funded from the deceased estate. If you already have a family trust, your estate plan may well need both structures to achieve the right outcome.

The testamentary trust arises under the will on the deceased’s death, but the practical transfer of assets into the trust generally occurs as part of the administration and distribution of the deceased estate. There is typically a period between death and distribution during which assets are managed as part of the estate itself. A financial planner in Brisbane can help you think through these sequencing considerations as part of a broader estate planning conversation.

 

How a Testamentary Trust Differs from a Standard Bequest

With a standard bequest, assets transfer directly to the beneficiary and become theirs outright. That simplicity is fine in many circumstances, but it also means the inheritance is:

• • Immediately accessible and potentially spent
  • Exposed to claims from creditors
  • Treated as the beneficiary’s personal property in family law proceedings
  • Potentially taxed in the beneficiary’s hands

A testamentary trust changes each of these outcomes. The assets remain within the trust structure, managed by the trustee according to the terms of the trust deed. Beneficiaries receive distributions at the trustee’s discretion rather than a lump sum they control outright.

 

Testamentary Trust Explained And What It Protects Against

One of the most important things a testamentary trust explained correctly will clarify is the range of protections it can provide. These are not absolute, but they are meaningful.

Relationship Breakdown

Assets held in a discretionary trust where the beneficiary is not the sole trustee are generally not treated as the beneficiary’s personal property in the same way an outright inheritance would be. Under the Family Law Act, the Family Court has broad discretionary powers and can take trust assets into account when determining property settlements. However, where the beneficiary does not control the trust, and where the trust deed is carefully drafted to reflect that the assets benefit a class of beneficiaries rather than one individual, the degree of protection is meaningfully greater than with a direct bequest.

Courts have looked through trust structures in some circumstances, particularly where the beneficiary has effective control over the trust or where the trust appears designed primarily as a device to defeat a spouse’s claims. The degree of protection depends significantly on how the trust is structured, who serves as trustee, and how the trust has operated. This is why the drafting of the trust deed matters and why specialist legal advice is essential.

Creditor Claims

If a beneficiary faces financial difficulty, assets held in a testamentary trust are generally harder for creditors to access than assets held outright. This is because the assets belong to the trust, not the beneficiary. Whether a particular creditor can access trust assets depends on the circumstances and the trust’s structure, but the protection is real and often significant.

Spendthrift Beneficiaries

Where you are concerned that a beneficiary might make poor financial decisions with a lump sum inheritance, a testamentary trust allows the trustee to manage distributions over time. This protects the inheritance without requiring you to be controlling or prescriptive in your will.

Blended Families

A testamentary trust can also address the specific complexities of blended families. Rather than creating a single trust for all beneficiaries, a single will can establish separate testamentary trusts for different beneficiaries or branches of the family. A parent might create one trust for their own children and another for a surviving spouse, each with different trustee arrangements and distribution terms. This flexibility makes testamentary trusts a particularly valuable tool for second marriages or blended family situations.

 

Testamentary Trust Tax Benefits: The Minor Children Advantage

Under normal circumstances, income distributed from a discretionary family trust to a minor is taxed at penalty rates. The ATO applies what is sometimes called the kiddie tax, with rates reaching 45% plus the Medicare Levy on amounts above a low threshold. This is designed to prevent income splitting with children.

Income distributed to minor beneficiaries from a testamentary trust is treated differently. Where the income qualifies as excepted trust income under section 102AG (because it is derived from estatesourced property), the ATO taxes minors at ordinary adult marginal rates. This means each minor beneficiary can access the full taxfree threshold of $18,200 (depending on other income, may effectively receive a bit more before paying tax due to the low-income tax offset). To access this concessional treatment, the trust must meet specific ATO requirements.

It is also important to understand that this concessional treatment applies to income distributed from the trust, not to capital distributions. Capital and income are treated differently, and this distinction affects planning decisions.

Crucially, the concessional tax treatment for minors only applies to income derived from estatesourced property. That is, assets transferred via your will (or codicil or intestacy) and any proceeds or reinvestments of those assets. If unrelated assets are later contributed to the testamentary trust, income from those additional assets distributed to minors will generally be taxed at penalty rates under Division 6AA.

Capital Gains Tax

Testamentary trusts also carry specific CGT implications. Where the estate includes investment properties or share portfolios, there are important rules around the CGT cost base of assets inherited from a deceased estate and how the trustee’s future disposal of those assets will be treated.

From 1 July 2027, the federal government is replacing the 50% CGT discount (for many taxpayers) with cost base indexation plus a 30% minimum tax on net capital gains. Importantly, deceased estates and testamentary trusts are excluded from this 30% minimum trust tax, so capital gains distributed from a genuine testamentary trust continue to be taxed under the existing deceased estate and trust rules.

If you are considering selling investment property as part of estate or succession planning, this does not need to be covered in depth here, but it should be raised with your adviser as part of any estate planning conversation.

 

Choosing Your Trustee

The testamentary trust is managed by a trustee you appoint in your will, and the choice of trustee has real implications for both the trust’s effectiveness and the protection it provides.

An individual trustee could be a family member, a trusted friend, or a professional. A corporate trustee is a company that performs the trustee role, which can offer continuity if individuals die or become incapacitated. The right choice depends on your circumstances.

One important consideration is whether a beneficiary can also serve as trustee. This is generally permitted, but where asset protection from creditors or a former partner is a primary concern, having the beneficiary as sole trustee reduces the protection the structure provides. If protection is the primary goal, an independent trustee, someone who is not a beneficiary, provides stronger insulation.

Your trust deed should also nominate a replacement trustee in case the original trustee is unable or unwilling to act. Your solicitor can advise on the appropriate trustee arrangements for your situation.

 

Is a Testamentary Trust Right for Your Situation?

A testamentary trust involves additional legal costs to establish and ongoing administrative obligations, including tax returns for the trust each year. For smaller estates or straightforward family structures, these costs may outweigh the benefits.

A testamentary trust is most likely to be worthwhile if one or more of the following apply:

• • Your estate is likely to generate meaningful ongoing income after your death
  • You have minor children who will be beneficiaries
  • You are concerned about a beneficiary’s relationship stability or financial resilience
  • Creditor risk is a relevant concern for one or more beneficiaries
  • You have a blended family with different branches who should be treated separately
  • Your estate includes investment properties or a share portfolio

If your estate is relatively modest, your beneficiaries are financially stable adults in secure relationships, and ongoing income generation is limited, a well-drafted standard will may be entirely sufficient.