The “5 and 5 power” rule, also known as the “5 by 5 power” or “5 or 5 power” clause, is sometimes instated in trusts to let beneficiaries to a trust withdraw a certain amount of value from the trust every year before it is officially scheduled to distribute itself. To understand why this might be necessary, it is important to understand how trusts work and how they integrate into estate plans in general.
What Is a Trust in Estate Planning?
A trust is a legal entity created and ratified by a trust document. Its contents (which is where its value comes from) are listed in the document but must often be separately funded into the trust (through deeds and amended ownership documents) to reflect their new status.
Trusts can hold property, assets, and cash “in trust” for one or more beneficiaries, and trusts are usually managed by either the trustor/grantor (creator of the trust) or one or more secondary trustees (trust managers). One of the more common uses of trusts in estate planning is to hold property and assets until the trustor dies.
The trust’s contents are distributed to its beneficiaries as per the terms of the document. In this case, trusts provide trustors with an immense amount of control over how and when assets should be distributed. Trust documents can be written to explain a trust’s purpose and specialization further.
However, most trusts can be categorized as either revocable (wherein the trust contents are often still within the trustor’s control) or irrevocable (which often further separates a trust from its trustor tax planning purposes). Other estate planning benefits of a trust include:
- The ability to reduce an individual’s probatable estate and thus opt for a shorter probate process.
- And greater privacy for the trust’s contents upon death (as assets and property in a probate process become part of the public record).
Trusts or Wills?
One of the benefits of trusts over wills is the increased control over how and when assets are distributed. But this control comes at a price, as trusts are more expensive to set up and manage in the long-term, whereas wills are a simple document drafted, signed, and notarized, with no other attached costs until probate.
There are cases – especially when estates are complex or particularly large – where trusts can greatly simplify the distribution and inheritance of assets and property and save a lot of time, money, and stress. Trusts are lauded for their flexibility and ability to provide many tax benefits for individuals worried about their own death’s tax impact.
In most cases, it is a false dichotomy either way. Trusts do not eliminate the need for wills, as a will should still be used to name guardians for minor dependents or pour certain assets left unfunded after death into a trust posthumously.
Explaining the 5 and 5 Power
The 5 and 5 power clause exists to either effectively minimize capital gains taxes on the contents of a trust or distribute a large sum of money piece-by-piece over a period of multiple years. It is defined by the annual distribution of the greater of either:
- $5,000, or
- 5 percent of the trust’s total fair market value
Trusts can be written to be distributed over several years through a 5 and 5 power clause, regardless of whether the trustor is dead or alive. Should a beneficiary become the trust owner, they will inherit the income and capital gains taxes associated with it. To understand how a 5 and 5 power can help beneficiaries reduce their tax liabilities with a trust, let us take a quick look at the basics of how most trusts are taxed.
Beneficiaries must pay income tax on the distributions they receive from a trust. The trust itself is also a taxable entity. However, income paid out as distributions can be written off as a deductible by the trust (because trusts are not subject to double taxation). The trust’s principal, however, is not taxable.
It is also worth mentioning that property transferred through a trust from the original owner to the beneficiary gains a step-up in basis when distributed after death, eliminating capital gains taxes previously owed on the property by the decedent.
5 and 5 power allows beneficiaries to reduce capital gains taxes on the income, interest, and dividends generated by the trust’s taxable contents by taking a distribution out of the trust, rather than letting it continue to accumulate value, which would result in a larger tax bill later.
Why and When Is the 5 and 5 Power Rule Instated?
The 5 and 5 power rule is typically instated when a trustor wishes to distribute the trust over time, rather than all at once. Trustors also can instruct trustees to limit distributions to certain conditions, such as tuition fees and educational costs, business startup capital, healthcare costs, or specific emergencies.
Other 5 by 5 Power Features
The 5 by 5 rule can be used in personal trusts, wherein the trustor and beneficiary are the same. In this case, the goal of the trust is not estate planning. Still, it is to hold, buy, and manage a property separate from the grantor (through an irrevocable personal trust), thereby benefitting off the income while hiring a trustee to manage the trust’s investments and income generation. Regardless of whether you would like to take advantage of the 5 and 5 power clause in a personal trust or for estate planning reasons, legal expertise and estate planning experience are necessary.
The Advantages of a Trust in Estate Planning
When leveraged properly, trusts can be an incredibly flexible estate planning tool to give you freedom over how and when to distribute your assets and limit your tax liabilities. However, it is key to prepare trusts with an experienced estate planning attorney to avoid unnecessary expenditures and needless complexity.