The 5 5 trust rule, also known as the 5 by 5 power, is a common provision in trust documents that allows a trust beneficiary to withdraw a limited amount of trust principal each year. This rule is a key element in certain types of trusts, often employed for tax planning purposes.
Understanding the 5 by 5 Power in Trust
A 5 by 5 Power in Trust is a specific clause included in a trust agreement that grants the beneficiary a non-cumulative right to withdraw a portion of the trust's principal annually. This power is designed to provide beneficiaries with some access to trust assets while also having significant implications for the tax treatment of gifts made to the trust.
Annual Withdrawal Limits
The core of the 5 by 5 power defines the maximum amount a beneficiary can withdraw from the trust each year. The beneficiary can cash out whichever is a higher amount between:
- $5,000
- OR 5% of the trust's fair market value (FMV)
This means that if 5% of the trust's value is less than $5,000, the beneficiary can still withdraw up to $5,000. If 5% of the trust's value exceeds $5,000, the beneficiary can withdraw the larger 5% amount. This provides a balance, ensuring a minimum withdrawal amount while allowing the potential withdrawal to increase as the trust's value grows.
Practical Application of the Withdrawal Limit
Here's how the withdrawal limits would apply based on different trust values:
| Trust Fair Market Value | 5% of FMV | Minimum $5,000 | Maximum Annual Withdrawal |
|---|---|---|---|
| $80,000 | $4,000 | $5,000 | $5,000 |
| $100,000 | $5,000 | $5,000 | $5,000 |
| $200,000 | $10,000 | $5,000 | $10,000 |
| $500,000 | $25,000 | $5,000 | $25,000 |
As illustrated, the beneficiary's withdrawal right adjusts with the trust's valuation, providing flexibility over time.
Key Characteristics and Uses
The 5 5 trust rule is a critical feature in certain trust structures, particularly those designed to minimize gift taxes.
- Tax Treatment of Gifts: The primary reason for including a 5 by 5 power in many trusts, especially irrevocable life insurance trusts (ILITs) or Crummey trusts, is to allow contributions to the trust to qualify for the annual gift tax exclusion. Without this present interest (the beneficiary's right to withdraw), gifts to an irrevocable trust might be considered future interests and thus not qualify for the exclusion.
- Beneficiary Access: It offers beneficiaries limited, direct access to the trust's principal, which can be useful for minor expenses or as an emergency fund without requiring trustee discretion for every small distribution.
- Non-Cumulative: The "non-cumulative" aspect means that if the beneficiary does not exercise the right to withdraw in a given year, that right typically lapses and cannot be carried over to future years. This prevents the beneficiary from accumulating a large, unrestricted withdrawal right over time.
- Balancing Control: The 5 by 5 power strikes a balance between the grantor's desire to keep assets within the trust for long-term purposes and the need to provide beneficiaries with some level of immediate access or control for tax efficiency.
The 5 by 5 power is a sophisticated tool in estate and trust planning, designed to provide beneficiaries with flexibility while adhering to tax regulations.
