As part of their estate planning, people often hand down inheritances to beneficiaries by setting up trusts rather than designating that they receive a specific amount of money or other assets in a lump sum.
Often, trusts are established to help ensure that the assets last over a period of time. The trustee may be charged with managing the assets so that they grow and provide regular income to the beneficiary.
A trust may be established to hold assets until a beneficiary is a legal adult or reaches some other specified age or milestone. A trust can also be a way to leave an inheritance to a beneficiary who may not yet be capable of handling the entire amount responsibly. Many trusts are established in such a way that the assets can’t be taken by creditors or divorcing spouses.
Some grantors (those who establish a trust) include something called a “5 by 5 power clause.” This gives the beneficiary the right to take up to either $5,000 or 5% of the trust’s fair market value (FMV) – whichever amount is greater — each year in addition to any regular income the trust is set up to pay them.
Why allow this extra amount to be withdrawn?
A primary reason that grantors include this clause is to guarantee that the beneficiary gets at least a minimum amount of money from the trust every year even if the value of the assets in the trust decreases – for example, due to stock market fluctuations. Typically, that regular income is a percentage of the trust value, so it could potentially vary significantly each year.
The ability to take additional withdrawals can also help minimize the amount of capital gains for the trust in a particular year. It’s important to understand the potential tax implications, both when establishing the trust and, for the beneficiary, when making withdrawals from it.
This clause, as we noted, generally is used when a trust is established to generate regular income – usually over many years. It likely wouldn’t be appropriate if you were establishing a “conditional” or “spendthrift” trust for someone who needs to have their inheritance carefully managed and distributed only as you’ve designated and. When establishing any type of trust, it’s crucial to have experienced estate planning guidance to help ensure that it meets your needs and those of your beneficiary.
