Using a testamentary trust in your estate planning lets you dictate the terms and conditions under which your beneficiaries receive assets from your estate. A testamentary trust, therefore, is a particularly suitable estate planning option if your heirs include children under the age of majority.
Testamentary trust vs. living trust
Living trusts and testamentary trusts are two very different legal arrangements, each of which can be useful depending on your particular circumstances:
- A testamentary trust is set up in your will, sometimes referred to as a last will and testament. While your will provides specific instructions on how the trust should be structured, the actual creation of a testamentary trust cannot occur until after your death.
- A living trust is a trust that the creator, also known as a grantor or settlor, sets up and transfers assets into while they are still alive. Also known as inter vivos and revocable trusts, living trusts are particularly advantageous if you have a lot of assets and expect to leave behind a relatively large estate.
Although living trusts can initially be more costly to set up than testamentary trusts, a testamentary trust can potentially incur more significant costs post-creation because your trustee usually must appear before the probate court on an annual basis until all distributions have been made. The purpose of these appearances is to show the court that the trustee has been dealing responsibly with the trust's assets. The trust incurs the costs associated with each of these probate appearances.
Testamentary trusts and the probate process
Setting up an irrevocable living trust, which cannot be changed or terminated by the granter, can help to keep some of your assets out of the probate process. While you can choose whether you want to create a revocable or irrevocable living trust, once a testamentary trust has been created through the probate process, as described below, it becomes irrevocable.
However, while you are still alive, you can revoke a testamentary trust at any time because it doesn't legally exist yet; you have merely provided instructions for its creation in the terms of your will.
By changing the will's wording, you can make changes to the terms of any testamentary trusts you have provided for. Once probate begins, estate assets are placed into the testamentary trust as provided for in the terms of your will, and the trustee is charged with handling these assets and making distributions in accordance with your will's instructions.
Creating a testamentary trust
You begin the process of creating a testamentary trust during the drafting of your will by including wording that sets up the trust, including naming the assets to be included, the trustee who will be in charge, and the trust's beneficiaries. Any conditions you want to place on the distribution of trust assets should also be included in your will. For example, you can include wording to set up a testamentary trust for your children with the condition that they do not have access to the funds until they are 25 years of age.
The ability to implement these kinds of conditions is one of the reasons why testamentary trusts can be useful if you have minor children and want to keep their inheritance safe until they are mature enough to handle the funds on their own.
Taxation of testamentary trusts
Once a testamentary trust has been created, it becomes a taxable entity in its own right and is thus subject to income taxes. If it has $600 or more in annual income, it must file a U.S. Income Tax Return for Estates and Trusts (Form 1041) for that year.
Generally speaking, income generated by a trust is not subject to double taxation, which means that taxes on trust income are paid by either the trust or by the beneficiary, but not by both. While the concept is simple, testamentary trust taxation can get quite complex because the amount of tax payable by beneficiaries also depends on whether the distribution comes from trust income, the principal of the trust, or a combination of both. Whenever a beneficiary receives distributions from a trust, they also receive a form known as Partner's Share of Income, Deductions, Credits, Etc. (Form 1065, Schedule K-1), which states how much of the distributions they received from the trust must be reported on their personal income tax return.
Like the living trust, testamentary trusts can be invaluable tools in the estate planning process. If you're unsure whether a testamentary trust is right for your situation, consider using an online service provider to help you decide and, if applicable, set it up for you.
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