5 by 5 Power Basics and Considerations
What is a 5 by 5 Power? A 5 by 5 power, or right of withdrawal, is a power provided to a beneficiary to withdraw principal from the trust within a specified period. This power must be specifically referenced in the governing instrument.
The power will allow a beneficiary to take up to 5% or $5,000 (oftentimes it is whichever is greater) in the form of a distribution. If the governing instrument has a right of withdrawal, the beneficiary must notify the trustee, within a reasonable time, of their ability to exercise the power; and, the beneficiary must indicate their desire to exercise the power in part or in total.
Let us explore a few considerations as to why a Grantor would provide this power in a governing instrument.
First, it allows for creativity for Grantors and Settlors. A 5 by 5 power creates flexibility if Grantors and Settlors are concerned with leaving a large amount of money to beneficiaries, especially if they are financially incompetent. A 5 by 5 power can set parameters on when a beneficiary can access funds. As an example, a Grantor can mandate that a beneficiary can only access funds if he or she needs to pay for anything that is for constructive purposes; like purchasing a home or pursuing post-secondary education. More common parameters could include healthcare, and/or emergencies.
Second, this power crates flexibility for trust beneficiaries. If a trust that has only ascertainable standards regarding distributions that can be made by the trustee to the beneficiary (health, education, maintenance, and support), this power provides tremendous flexibility with access to additional funds without the use of a discretionary distribution. If a trustee is particularly strict regarding these standards, and as a result, the beneficiary cannot access as much funds as he or she desires, the 5 by 5 power can allow the beneficiary to make a withdrawal of the trust’s assets annually – for any reason. While this can be viewed as an advantage for the beneficiary it can also be viewed as a disadvantage as it could potentially allow the beneficiary to deplete a trust more rapidly over time and therefore not leaving enough wealth to transfer to future generations.
Third, the potential tax implications. Beneficiaries are required to pay income on the distributions they receive from a trust. A trust is its own taxable entity, but income paid out as distributions can be written off as deductible by the trust. 5 by 5 powers enable beneficiaries to reduce capital gains taxes on the income, interest and dividends generated by the trust’s taxable assets. The IRS looks at a 5 by 5 powerholder as the owner of the trust up to the amount of the power. As such, $5,000 or 5% of the trust is going to be taxed to the beneficiary regardless of whether they elect to use this power or they do not elect to use this power.
In closing, this is a basic planning tool and there should be considerations when it comes to 5 by 5 powers, but they allow different avenues to be explored when creating a trust. I personally administer a fair number of trusts with 5 by 5 powers in my role as a Trust Officer at First State Trust Company. In my opinion, I do believe that 5 by 5 powers are beneficial to include in the drafting of trust agreements in order to provide more flexibility. If you have interest to include a 5 by 5 power in a trust, please consult with an attorney to assist you in drafting the trust agreement or feel free to reach out with any questions at 302-573-5959.
Christopher Carr, Vice President and Trust Officer
ccarr@fs-trust.com
The posts expressed are views of FSTC and are not intended as advice or recommendations. For informational purposes only. FSTC does not offer tax, legal, or investment advice, professional counsel should be sought for tax or legal advice.