What Is 5 by 5 Power?
A 5 by 5 power clause in a trust document gives the beneficiary the right to withdraw either $5,000 or 5% of the fair market value of the trust account per year, whichever is greater. This is in addition to the regular income payout benefit of the trust.
The clause is intended to guarantee the beneficiary a minimum dollar distribution in years in which the assets invested for the trust decline.
- A trust is established in a will in order to provide a regular annual income to one or more beneficiaries from the assets of the estate.
- A 5 by 5 power clause in a trust allows the beneficiaries access to an additional amount each year if needed.
- The amount is the greater of $5,000 or 5% of the estate assets.
- One of the greatest powers of the 5 by 5 is that distributions taken by the beneficiary can be written off as deductible.
Understanding 5 by 5 Power in a Trust
A trust is an alternative to a lump-sum inheritance. Instead of willing a large amount of money with no strings attached, a wealthy individual may put the money in a trust. The money is then invested and the heirs are paid a predetermined amount of money annually, usually a percentage of the value of the trust.
The trust may be designed to protect the interests of minor children, infirm heirs, or offspring that the beneficiary, rightly or wrongly, doesn't consider capable of handling a fortune wisely. This allows the beneficiary to still financially benefit, but forces them to work within the budget of the clause.
The 5 by 5 clause may be included to give the heirs access to an additional amount of money yearly without giving them the ability to decimate the value of the estate. It is particularly useful if the annual payment falls short due to a decline in the investments held in the trust.
One of the core benefits of the 5 by 5 clause is that the beneficiary is allowed by the IRS to reduce capital gains on the income, interest, and dividends generated by the trust's taxable assets.
Tying Up the Money
It is not uncommon for wealthy individuals to attach strings to the money they leave to their heirs. The ways that high-net-worth individuals protect their money, even after deaths, include the following:
- Spendthrift clauses protect the money held in the trust from creditors pursuing payment from the beneficiaries of the trust.
- Age minimums specified in a trust delay payments until the beneficiaries reach a certain age, typically 25.
- A clause may forbid the beneficiary from selling interest in the trust in order to raise cash.
- A "no contest" clause may disinherit any beneficiary who challenges the terms of the trust.
The Advisor Insight
Adam Harding, CFP®
Adam C. Harding, CFP® Investments & Financial Planning, Scottsdale, AZ
The primary reason individuals create a trust is to establish detailed instructions for the delivery of their assets after they have passed and can't direct the assets themselves. Where a will can instruct a one-time delivery of assets, the structure of a trust can provide ongoing guidance.
The “5 by 5 Power” is simply a way to provide some parameters around the access a beneficiary has to the funds in a trust. It basically means that in each calendar year, they have access to $5,000 or 5% of the trust assets, whichever is greater.
So if the trust has $10,000 in it, a beneficiary can take out $5,000 even though this is 50% of the trust corpus. Conversely, if the trust has $10 million, the beneficiary can withdraw $500,000 under this arrangement.