5 by 5 Power: What It Means, How It Works

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.

What You Need to Know

• A trust is established in a will in order to provide a regular annual income to one or more beneficiaries from the assets of an estate.
• A 5 by 5 power clause in a trust allows the beneficiaries access to an additional amount each year.
• The amount is the greater of $5,000 or 5% of the estate’s assets.
• With the 5 by 5 power, 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 bequeathing 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, which is usually a percentage of the value of the trust.

The trust may be designed to protect the interests of minor children or offspring that the grantor, 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 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 Internal Revenue Service (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 their deaths, include the following:

• Spendthrift clauses protect the money from creditors who are pursuing payment from the beneficiaries of the trust.
• Age minimums specified delay payments until the beneficiaries reach a certain age, such as 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®
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.

What Is a Beneficiary?

A beneficiary is an individual or entity (such as a nonprofit organization) who receives assets from a trust that was set up by someone else.

What Is a Grantor?

A grantor is an individual who creates a trust. This person is sometimes called a testor or settler.

What Is a Trust?

In estate planning, a trust is a tool that can be used to protect assets from bankruptcy and creditors. In some cases, it can also protect assets if the beneficiary does not spend money in a responsible way. It is set up during the grantor’s lifetime, typically to be distributed after the grantor has died. (An exception is a special needs trust, when the grantor is often alive while the assets are being distributed.)

The Bottom Line

If there’s a 5 by 5 power clause in a trust document, the beneficiary can withdraw a part of the trust’s value each year. That amount is either 5% of the estate’s assets or $5,000, whichever is greater.