It is not uncommon for wealthy individuals leaving large sums of money to certain beneficiaries to be concerned with just how responsible those people will be with it. When leaving large sums of money to some people, it is certainly conceivable that they some will spend (or blow) that massive chunk of cash in ways the benefactor might not agree with. Well, to resolve this dilemma, and to provide access to funds if income for a given year was low, trusts can include a "5 by 5 Power" to allow greater flexibility.
What Is a Trust?
A trust is a fiduciary relationship where one party is given responsibility over and holds funds for the benefit of a third party. Trusts are established to provide legal protection for funds and assets, as well as to ensure that the funds are distributed in accordance with the benefactor's wishes. Trusts can also be used for tax benefits and planning purposes. This is particularly useful for estate planning purposes.
Trusts (other than charitable trusts) are often used to provide children of high-net-worth people with a controlled, long-lasting income. But they can also be established to ensure support is provided for physically or mentally handicapped loved ones, even after the benefactor's death.
A majority of trusts are established to protect assets and to provide for the ongoing well being of a specific loved one. In doing this, these trusts typically allow the beneficiary access to funds from the trust for an ascertainable standard relating to their health, education, support and maintenance. Basically, an allowance. Many trusts will also allow the beneficiary access to the income that is produced from the trust's investments each year.
What Is "5 by 5 Power"?
In addition to this ascertainable standard and income payout benefit, the "5 by 5 Power" can be added to a trust's bylaws, which allows access to the greater of: a) $5,000 per year, or b) 5% of the fair market value of the trust per year. This can help to guarantee an income beneficiary a minimum dollar distribution, regardless of the income generated from the trust. Be aware: Should the beneficiary elect NOT to exercise their "5 by 5 Power" over the year(s), adverse tax consequences could arise.
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 they can withdraw $500,000 under this arrangement.