Testamentary Trusts: What They Are and How They Work

Trusts are often a key part of an estate plan, helping you protect your wealth and legacy. There are, however, many different types, each serving a distinct purpose. One of the most common is a testamentary trust. Also known as a “will trust,” this arrangement is created through a “last will and testament” and only becomes active after someone passes away.

In this article, we’ll offer an overview of the basics of testamentary trusts, how they work, their pros and cons, and the steps involved in setting them up. We’ll also highlight how an estate planning professional or financial advisor can be an invaluable resource as you plan a trust’s place in your estate.

What Is a Testamentary Trust?

A testamentary trust is written into a person’s last will and testament. It springs into effect after the will is submitted to probate following someone’s passing and outlines how assets must be held by a trustee, such as a financial advisor, attorney, or other individual, and eventually distributed to heirs.

Testamentary trusts can hold any property you want to have kept until your beneficiaries (e.g., children, grandchildren, siblings, or other relatives) are of age or able to receive it. For example, you may want to pass on some of your savings to your grandchild, but only once they turn 21. In this case, the funds can stay invested or earn compound interest in the trust until they’re old enough to receive the money.

A single will could include one or more testamentary trusts, which can be used to allocate parts of your estate to specific people while the assets are in the trust. You may have multiple children or grandchildren and might want each to have funds.

It’s important to note that testamentary trusts fall under the supervision of the probate court. Since they exist after the grantor’s death, the trustee must periodically check in with probate officials to verify that the trust is being managed properly and in the beneficiaries’ best interests.

How a Testamentary Trust Works

On the surface, testamentary trusts may seem complex because they involve multiple moving parts. For instance, they only go into effect upon death, require probate, and rely on a trustee to manage the trust until beneficiaries can receive its proceeds. Below is a brief breakdown of how these trusts work in practice:

Created Through a Will

As mentioned, testamentary trusts are part of a will. Like other trusts, they involve setting forth their terms while the person is alive; however, they only become active once a person (the testator) dies and the will goes through probate.

“Before someone dies, a testamentary trust is just a placeholder within a will and stipulates that upon death the trust becomes irrevocable. Until that time, assuming the person is alive and competent, they can change the trust that is within the will at any point,” explains Todd Villarrubia, 30-year tax attorney and owner of Wealth Planning Law Group.

How Assets Flow Into the Trust

Because they’re part of a will, testamentary trusts are subject to the probate court. This plays a critical role in ensuring the trustee carries out the interests of the deceased and their beneficiaries, while properly directing the assets within the trust.

“The probate court will authorize the creation of the testamentary trust,” says Geoff Hoatson, CEO and founding attorney of Family First Firm Elder Law. He notes, however, that this can be “confusing to many people who believe that trusts ‘avoid probate’ when, in fact, a testamentary trust can only be created through the probate process.”

Before property can enter the testamentary trust, the will must pass probate and complete validation. Subsequently, the executor oversees the creation of the trust and the transfer of specific assets (cash, investments, real estate, etc.).

Probate’s involvement with a testamentary trust can be a downside. As Hoatson points out, an advantage of other types of trusts is that they avoid court oversight, but that isn’t true with testamentary arrangements. They’re put through the arduous and expensive probate process that comes with will validation, as well as oversight of court professionals over the trust until the beneficiary can claim it.

“Many jurisdictions require periodic court accounting of the trust assets, especially if the beneficiaries are minors or disputes arise among them,” says Craig Parker, Assistant General Counsel at Trust & Will. “The degree of oversight provided by the courts increases the costs, time, and complexities associated with the administration of the trust.”

Trustee Duties

Once the assets are in the trust, a trustee must manage them as a fiduciary. This could be a vetted professional, such as a financial advisor or estate planning attorney, or another trusted individual, like a family member or the executor themself.

“A trustee must be a diligent bookkeeper,” says Allison Harrison, principal attorney and founder of ALH Law Group. “Their job is to keep track of assets, ensure the letter of the trust is followed, and keep records to substantiate any distributions.”

With testamentary trusts, the trustee also has a duty to comply with ongoing court oversight. This ensures that the individual or their employer is accountable to the interests of the deceased and the beneficiaries and properly supervises the holdings within the trust.

“The appointment of qualified trustees may be the single most important thing that you do when establishing a trust,” says Villarrubia. “It is important that the person be trustworthy, competent, and responsive to the needs of the beneficiaries. They should have financial confidence, strong organisational skills and the ability to make impartial decisions.”

Pros and Cons of Testamentary Trusts

As we’ve discussed above, testamentary trusts have both benefits and notable drawbacks. Like other trusts, they serve as a tool to protect assets for future generations, and especially those who may not yet be old or stable enough to collect their inheritance. However, they also undergo probate and only officially exist once a person passes away.

Below is a breakdown of the pros and cons:

Pros

• Controlled distribution. With the potential for one or more in a will, testamentary trusts allow control over the distribution of property for specific beneficiaries.
• Protection. Trusts can help protect assets from creditors and keep them invested until beneficiaries can receive them.
• No need to manage during life. Because it starts upon the validation of a will, there’s no need to manage the trust or part with funds during one’s lifetime.

Cons

• Requires probate. Testamentary trusts must endure probate, which is costly and lengthy.
• The trust assets are public. Due to being “written into the will, the trust and all of your assets become a matter of public record once the will is filed,” which decreases “privacy compared to a revocable living trust,” highlights Villarrubia.
• Trust doesn’t exist until death. While a benefit in some ways, the trust becomes irrevocable upon death, making changes difficult or impossible.
• Administrative cost and oversight. The probate process, ongoing oversight, and having a trustee can add up and cut into the trust’s value.
• Less flexibility than living trusts. Unlike living trusts, testamentary trusts are more rigid and only activate upon death. This requires more court supervision and makes them irrevocable.

When Does a Testamentary Trust Make Sense?

A testamentary trust may make sense as part of an estate plan in certain situations, but not all. This is especially true if you want to have more control over when funds transfer to beneficiaries.

One of the most common scenarios is defending and eventually dispersing assets, such as large sums of cash or investments, for minor children or grandchildren. With this, the trust acts as a contingency that springs into action if something happens to you.

Testamentary trusts “are a smart idea for any family with beneficiaries under the age of 18 (or in a few states 19),” says Harrison. “Anyone under the state’s age of majority cannot hold property in their name. Having the assets in the trust allows the trustee to distribute them to the minor as needed, so the minor has access to capital, even though they cannot ‘own’ them.”

Another advantage involves planning for spousal beneficiaries who receive governmental benefits or have special needs. “The situation that makes the most sense for usage of testamentary trusts is when a well spouse is planning for their Medicaid recipient spouse,” explains Hoatson. “In this case, a direct inheritance will generally disqualify the Medicaid recipient from his or her benefits,” he notes, adding that you could use a special needs trust (SNT) in a testamentary format as a solution: “The only recognized spousal SNT is a testamentary SNT, which is why these can be extremely powerful planning tools for people receiving government benefits.”

More broadly, a testamentary trust could be useful if you want to add another layer of structure or protection in your estate plan. Trusts can be strong tools and protect inheritances and assets against litigation, and a testamentary arrangement gives you one of those in your plan.

“The primary advantage is asset protection and control,” says Villarrubia. “A testamentary trust allows the assets held by the trust to be protected from threats of lawsuits, creditors, and in most states divorce in which case the creditor cannot reach the trust assets.”

Setting Up a Testamentary Trust and How an Expert Can Help

To establish a testamentary trust, it’s important to seek professional guidance. As noted, they are complex legal arrangements with multiple parts and steps. Therefore, before deciding whether to establish one and going through the setup process, it’s smart to meet with an estate planning attorney and, if applicable, consult with a financial advisor.

During the process, you’ll meet with an attorney to complete steps such as:

• Identifying beneficiaries
• Drafting the trust into your will
• Deciding which assets to fund the trust (e.g., cash, investments, real estate, etc.)
• Selecting a trustee
• Setting criteria on when beneficiaries should receive their benefits