Divorce and separation is never a pleasant or inexpensive process but it does provide a unique tax planning opportunity that few know about.  After separation one party is often required to pay child support to their former spouse. Depending on the age of the child, this could be for as long as 18 years.  This cost is ordinarily funded from post-tax earnings.  As an example, a taxpayer who has income in the highest marginal tax bracket is theoretically required to earn approximately $2 of income to be able to fund $1 of child support.

If you’re going through a separation there might be an opportunity for you to structure your assets in such a way to allow you to meet your child support obligations from pre-tax dollars – saving you tens of thousands in tax each year.  This is achieved by setting up a special Child Maintenance Trust.

If you’ve got a discretionary trust, you probably already know that the most you can distribute to children minors under the age of 18 is an insignificant $416 per year before that income is taxed at rates equal to and higher than 47%!  Often the administration involved in distributing such as small amount of income to a minor is not worth the trivial tax saving from doing so.

If you transfer assets into a special trust for the child then the special higher tax rates for minors mentioned above do not apply.  Any income distributed to the child are taxed at normal adult marginal tax rates – including the nil tax rate for the first $18,200!  Distributions to the child from this trust are counted towards child support obligations meaning there may be less or no amount that is required to be paid from your other post tax income.

Worked Example:

As an example, if a parent (who was already on the top marginal tax rate) had three children and was required to pay $60,000 in child support, the pre-tax income required is $113,207 and tax would be $53,207!  If the parent instead put sufficient assets into a child maintenance trust that generated $60,000 of income, which is distributed to the three children, then there would be no tax payable on that income.  That’s a significant saving of tax each and every year!

Are there any catches?

The trustee of the trust should be a parent of child or children who benefit under the trust who is no longer with their spouse.  Another requirement is that there must be a court order, child support assessment or agreement in place that mandates the parent to pay child support.  The last catch is that the assets within the trust must ultimately pass to the children (often once they turn 18). This is an important consideration as a parent may not be ready to gift such significant capital assets to their children.

With the compounding benefit of paying significantly lower taxes over a period that could be as long as 18 years, a child maintenance trust is definitely a worthwhile strategy to grow inter-generational wealth.