What it means
Trusts are legal arrangements where a trustee holds assets for the benefit of others. Sometimes a trust gives a beneficiary a right to take money out on demand, which is a type of general power of appointment.
Under US tax law, simply holding such a power can cause the assets to be counted in the beneficiary's own estate, and letting the power lapse can be treated as if the beneficiary had made a gift. The five by five rule is a safe harbour (a protected zone) that softens this effect.
If a beneficiary lets a withdrawal right lapse, it is treated as a gift only to the extent the lapsed amount exceeds the greater of $5,000 or 5% of the value of the assets that could have been withdrawn. A power limited to that amount each year is therefore a popular way to give flexibility at low tax risk.
Estate planners use it in several ways. A surviving spouse might receive income from a trust plus the right to take extra principal each year, up to the five by five limit, for emergencies.
Parents may also use it to give a child some control over a family trust without exposing the full fund to the child's creditors or estate. The right is non-cumulative in the typical drafting.
If the beneficiary does not use it in a given year, it lapses and does not roll over, so the beneficiary cannot save up several years of rights. This keeps the amount within the protected limit and the rest of the trust protected.
Because the rule sits in tax law and trust law, a lawyer should draft and review these provisions. The wording of the trust, the way assets are valued and local law all affect the outcome, and the tax rules can change.
This entry explains the concept only and is not advice for any particular trust.
In practice
Real-world examples.
Example
A widow benefits from a $1,200,000 family trust that pays her income. Its terms also let her withdraw up to the five by five amount each year, which is $60,000, if she has an unexpected medical bill.
Example
A father sets up a trust of $80,000 for his adult daughter, a freelance designer. She has the right to withdraw $5,000 a year, since that is greater than 5% of the trust, and she uses it in a slow year.
Example
A couple's estate lawyer drafts a trust with a withdrawal right limited to five by five. The right lapses each year if unused, so no large taxable gift is deemed to occur and the main fund stays protected.
Formula
Calculation
The annual withdrawal amount protected by the rule is the greater of two figures.
Protected amount = greater of ($5,000, 5% x Trust value)
Worked example 1: a trust is worth $400,000.
5% x $400,000 = $20,000
Greater of $5,000 and $20,000 = $20,000, so the beneficiary can withdraw up to $20,000 a year within the protected limit.
Worked example 2: a smaller trust is worth $60,000.
5% x $60,000 = $3,000
Greater of $5,000 and $3,000 = $5,000, so the $5,000 floor applies.
The crossover point is a trust of $100,000, because 5% x $100,000 = $5,000.Case study
Seen in the real world.
Hartley Family Trust is a fictional trust holding $500,000 for the benefit of Margaret, a retired teacher. Her husband's will gave her the income and a yearly right to withdraw principal limited to five by five. The trustee was a local bank.
In this illustrative case, Margaret withdrew $25,000 one year to replace her car, which was exactly 5% of $500,000. In other years she took nothing, and the right lapsed without any tax problem. The trust's remaining assets passed to her children as planned. The story shows how a modest, capped right can add flexibility without undoing the structure of the trust.
Watch out
Common mistakes.
- Believing the beneficiary can take any amount without consequences. The protection only applies up to the greater of $5,000 or 5%, and larger rights can create gift or estate tax issues.
- Assuming unused rights carry forward. In most designs they lapse each year, so a beneficiary who wants to build up a bigger pot cannot do so under this clause.
- Ignoring the trust's value at the right date. The 5% is measured against assets available at the time of lapse, so a falling or rising value changes the number.
Questions
People also ask.
What does five by five mean in plain English?
It means the beneficiary can withdraw each year the larger of $5,000 or 5% of the trust, and can let the right lapse without gift tax consequences up to that amount.
Is it a withdrawal right or a gift?
It is a withdrawal right. If it lapses, the tax law treats the lapse as a gift only above the five by five limit.
Is five by five the same as the phrase meaning loud and clear?
No. In radio language, five by five means a strong signal, but in trusts it is a tax rule. Context makes the meaning clear.
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