Trusts are often designed to accomplish two goals that can seem to compete with one another: protecting and preserving assets for the future while still giving beneficiaries meaningful access to those assets today. One estate-planning tool that can help strike that balance is commonly known as a “5-and-5 power.”
The name sounds technical, but the basic concept is relatively straightforward. A properly drafted trust can give a beneficiary the power to withdraw a limited amount of trust property each year. Under federal tax law, the relevant threshold is generally the greater of $5,000 or 5% of the aggregate value of the assets from which the withdrawal could be made.
That does not mean every trust automatically permits a 5% annual withdrawal. It also does not mean that a trust containing a HEMS distribution standard automatically contains a 5-and-5 power. These are separate concepts, and understanding the difference is important when creating or administering a trust.
What Is a 5-and-5 Power?
The term “5-and-5 power” comes from Section 2041 of the Internal Revenue Code.
A beneficiary may be given what tax law considers a general power of appointment over trust property. Generally speaking, a general power of appointment can create significant estate and gift tax consequences because the beneficiary has substantial control over the property.
Congress, however, created an important limitation for certain lapsing powers.
Under Internal Revenue Code Section 2041(b)(2), the lapse of a power of appointment during a calendar year is generally not treated as a release of that power to the extent the property that could have been appointed does not exceed the greater of:
- $5,000, or
- 5% of the aggregate value of the assets out of which the power could have been satisfied.
This is where the phrase “5-and-5” comes from.
Consider a trust with $5 million in assets. Five percent of $5 million is:
$5,000,000 × 5% = $250,000.
Because $250,000 is greater than $5,000, the relevant 5-and-5 amount would generally be $250,000, assuming the entire $5 million constitutes the property from which the power could be satisfied and the trust is drafted accordingly.
That calculation is simple. The tax and estate-planning consequences surrounding it are not.
A 5-and-5 Power Is Not the Same as HEMS
One of the most important distinctions in trust planning is the difference between a 5-and-5 withdrawal power and a HEMS distribution standard.
HEMS stands for:
Health, Education, Maintenance, and Support.
A trust might authorize a trustee to distribute assets to a beneficiary for these purposes. Depending on how the trust is written, the trustee may have considerable discretion in deciding whether a requested distribution falls within the HEMS standard.
A 5-and-5 power works differently.
When a beneficiary possesses a true withdrawal power, the beneficiary may have the legal authority to demand the specified amount without first demonstrating that the money is needed for health, education, maintenance, or support.
Suppose a $5 million trust provides that the trustee may make distributions to John for John’s health, education, maintenance, and support.
John asks for $250,000.
John cannot simply say, “That’s 5% of the trust, so I’m entitled to it.”
The HEMS provision must be applied according to the language of the trust.
Now suppose the same trust separately gives John an annual withdrawal power over an amount equal to the greater of $5,000 or 5% of the applicable trust assets.
That creates a very different analysis. John may possess a direct withdrawal right over the amount specified by the trust.
The distinction is critical.
Why Would Someone Give a Beneficiary a Withdrawal Power?
At first glance, giving a beneficiary the right to withdraw hundreds of thousands of dollars from a trust may seem inconsistent with the purpose of creating a trust.
Why place assets in trust if the beneficiary can simply withdraw them?
The answer is that sophisticated trust planning is rarely about maximizing restrictions or maximizing access. It is usually about determining the appropriate amount of control, protection, flexibility, and tax efficiency for a particular family.
A beneficiary might need significant financial flexibility while the person creating the trust still wants the remaining assets professionally managed and protected within the trust structure.
For example, imagine a parent establishes a substantial trust for an adult child. The parent wants the trust to provide long-term financial security but does not necessarily want the adult child to depend on a trustee for every significant financial decision.
An appropriately drafted withdrawal provision can provide a degree of independence.
At the same time, assets that remain inside the trust may continue to receive whatever benefits the trust structure otherwise provides, subject to applicable law and the specific terms of the trust.
How the 5% Calculation Works
The percentage calculation itself is straightforward, although determining which assets are included in the calculation can require professional analysis.
For illustration:
A $500,000 applicable asset base would produce a 5% figure of $25,000.
A $1 million applicable asset base would produce a 5% figure of $50,000.
A $2 million applicable asset base would produce a 5% figure of $100,000.
A $5 million applicable asset base would produce a 5% figure of $250,000.
A $10 million applicable asset base would produce a 5% figure of $500,000.
For trusts worth more than $100,000, 5% will obviously exceed $5,000.
But the calculation should not be treated as simply “5% of whatever number appears on the trust’s latest statement.” Section 2041 refers to the aggregate value of the assets out of which, or the proceeds of which, the exercise of the lapsed power could have been satisfied.
That distinction can matter.
The trust’s provisions, the scope of the beneficiary’s power, valuation issues, and the assets subject to that power should therefore be reviewed carefully.
What Happens If the Beneficiary Doesn’t Take the Money?
This is where the tax planning behind the 5-and-5 concept becomes particularly important.
Suppose a beneficiary has a withdrawal power but decides not to exercise it.
The withdrawal right eventually expires or “lapses.”
Ordinarily, the lapse of certain powers can create tax consequences because tax law may treat the beneficiary as having relinquished control over property.
Section 2041(b)(2) provides special treatment for the lapse of a power within the statutory 5-and-5 threshold.
This statutory rule is the real reason the 5-and-5 concept matters.
It is therefore somewhat misleading to think of the rule merely as permission for someone to “take 5% out of a trust every year.” The provision is fundamentally part of the federal transfer-tax rules governing powers of appointment and the consequences when those powers lapse.
What If the Withdrawal Right Exceeds 5-and-5?
This is another area where careful drafting becomes essential.
A trust could theoretically grant a beneficiary a withdrawal power exceeding the 5-and-5 amount. But the favorable lapse rule only extends to the statutory threshold.
If a beneficiary has a larger power and allows it to lapse, the excess can potentially be treated as a release of a general power of appointment. That can lead to gift-tax and other transfer-tax consequences.
This is why attorneys sometimes use additional mechanisms when designing trusts with larger withdrawal rights.
The appropriate solution depends heavily on the objectives of the trust, the beneficiary’s circumstances, the size of the trust, and current tax law.
A beneficiary should therefore not assume that a larger withdrawal right can simply be allowed to expire without consequences.
The Estate Tax Issue
A general power of appointment can also have estate-tax consequences.
Under Internal Revenue Code Section 2041, property over which a decedent possesses certain general powers of appointment may be included in the decedent’s gross estate.
This is another reason the details matter.
The 5-and-5 lapse rule does not mean that a beneficiary can possess unlimited control over trust property without potential estate-tax consequences. Instead, the Code contains detailed rules governing the creation, exercise, release, and lapse of powers.
The tax treatment can also become more complicated when powers accumulate over multiple years or when the beneficiary’s rights are structured in particular ways.
For a multimillion-dollar trust, these issues can involve significant amounts of money. The difference between properly and improperly structuring a withdrawal right can therefore be substantial.
5-and-5 Powers and Asset Protection
People also frequently assume that assets held in trust are automatically protected from creditors.
That is too broad a statement.
Creditor protection is highly dependent on state law, the type of trust, spendthrift provisions, who created the trust, the beneficiary’s rights, and the amount of control the beneficiary possesses.
A withdrawal power can be especially important to this analysis.
If a beneficiary has an immediate legal right to demand trust property, applicable law may treat the assets subject to that withdrawal right differently from assets that remain entirely within a trustee’s discretion.
Consequently, increasing a beneficiary’s control can sometimes come at the expense of protection.
This illustrates a recurring principle of trust planning:
More beneficiary control is not always better.
A trust designed primarily to protect assets may appropriately provide less direct access. A trust designed primarily to give a responsible adult beneficiary flexibility may intentionally provide more.
There is no universally correct structure.
Combining HEMS With a 5-and-5 Power
A trust does not necessarily have to choose between HEMS and a withdrawal power.
Depending on the planning objectives, a trust could contain both.
For example, a trust might provide:
- Trustee discretion to make distributions for the beneficiary’s health, education, maintenance, and support; and
- A separately defined annual withdrawal right.
These provisions perform different functions.
The HEMS provision can allow distributions based on the beneficiary’s needs and standard of living.
The withdrawal provision can provide the beneficiary with a defined amount of direct control.
Consider again a $5 million trust.
If the beneficiary possesses an appropriately drafted 5% withdrawal power covering the entire applicable asset base, the mathematical amount might be $250,000 for that year.
Separately, the trustee might possess authority to make HEMS distributions.
That does not necessarily mean the beneficiary can automatically receive $250,000 plus unlimited additional distributions. The trust agreement, fiduciary duties, tax consequences, governing state law, and interaction between provisions all have to be considered.
But conceptually, the two provisions can coexist.
Should the Beneficiary Exercise the Power Every Year?
Having the legal ability to withdraw money does not necessarily mean exercising that ability is the best financial decision.
Suppose a beneficiary can withdraw $250,000 but only needs $75,000.
Taking the full $250,000 simply because it is available could move an additional $175,000 outside the trust.
Depending on the circumstances, that money could lose protections it enjoyed while held in trust. It also becomes part of the beneficiary’s individually owned assets and may affect the beneficiary’s own estate plan.
There may therefore be good reasons to leave assets inside the trust.
On the other hand, a beneficiary may have legitimate reasons to exercise the withdrawal power, such as purchasing a residence, starting a business, investing outside the trust, making gifts, paying expenses, or simply obtaining greater control over personal finances.
The appropriate decision depends on the beneficiary’s overall financial and estate plan.
The Trustee and Beneficiary Should Understand Their Different Roles
Another potential source of confusion arises when the beneficiary asks the trustee for money.
With a discretionary distribution, the trustee generally acts pursuant to the distribution provisions of the trust and applicable fiduciary obligations.
With a withdrawal power, the beneficiary may instead be exercising a contractual or property right created by the trust instrument.
Those are not necessarily the same transaction.
Trust administration should reflect the distinction.
Records should identify whether money was distributed pursuant to a HEMS provision, another discretionary distribution provision, or the beneficiary’s exercise of a withdrawal power.
Good recordkeeping becomes especially important with substantial trusts because years later an accountant, attorney, beneficiary, successor trustee, creditor, or taxing authority may need to determine exactly what happened.
A $5 Million Example
Consider a hypothetical $5 million irrevocable trust created for an adult beneficiary.
The trust provides for discretionary HEMS distributions and also gives the beneficiary an annual withdrawal power drafted with reference to the 5-and-5 limitation.
Assume for simplicity that the full $5 million constitutes the relevant asset base.
Five percent equals:
$250,000.
The beneficiary might therefore have a $250,000 withdrawal right for that particular year under the terms of the trust.
But several separate questions should still be asked:
What assets are actually subject to the power?
The answer determines the proper 5% calculation.
When can the power be exercised?
The trust should establish the applicable procedure and timing.
What happens if the beneficiary does nothing?
The lapse provisions and resulting tax treatment need to be understood.
Does the beneficiary also receive HEMS distributions?
The trust should address the interaction between the provisions.
What happens to withdrawn assets?
Once distributed, those assets are generally owned individually by the beneficiary and may have a different creditor, marital-property, investment, and estate-planning profile.
What happens at the beneficiary’s death?
The estate-tax treatment of any powers held by the beneficiary should be reviewed.
These questions demonstrate why the phrase “the beneficiary can take 5% every year” is an oversimplification.
The Bigger Planning Question
The most useful question when creating a trust is usually not:
“How much can we let the beneficiary withdraw?”
A better question is:
“How much control should the beneficiary have while still accomplishing the purposes for which the trust was created?”
Those purposes might include long-term wealth preservation, estate-tax planning, creditor protection, divorce protection, financial management, multigenerational planning, or providing a beneficiary with a dependable source of support.
A 5-and-5 power is simply one tool available to help accomplish those objectives.
For one family, a substantial annual withdrawal right might provide exactly the desired balance between independence and protection.
For another, giving the beneficiary such a right could undermine the primary reason for establishing the trust.
Bottom Line
A 5-and-5 power can be a valuable component of sophisticated trust planning, but it is frequently misunderstood.
The rule originates in federal tax law and generally provides special treatment for the annual lapse of a power of appointment to the extent the property subject to the lapse does not exceed the greater of $5,000 or 5% of the applicable assets.
For a $5 million applicable asset base, 5% is $250,000.
But that does not mean every beneficiary of a $5 million trust can withdraw $250,000 annually. The trust must actually grant the beneficiary the relevant withdrawal power, and the precise terms of the trust determine the beneficiary’s rights.
It is also important not to confuse a 5-and-5 power with HEMS. A HEMS provision concerns distributions for health, education, maintenance, and support. A withdrawal power can give a beneficiary a separate right to obtain trust property without satisfying the HEMS standard.
For substantial trusts, the interaction among withdrawal rights, HEMS provisions, estate and gift taxes, creditor protection, fiduciary duties, and state trust law should be evaluated as part of the overall estate plan.
A properly structured trust is not simply about keeping money away from a beneficiary or giving the beneficiary unrestricted access. It is about finding the appropriate balance between access, control, protection, flexibility, and long-term preservation of wealth.
Because the consequences depend heavily on the trust’s exact language and applicable law, anyone considering adding, exercising, or allowing a 5-and-5 power to lapse should have the trust reviewed by qualified estate-planning and tax professionals.
This article is for general informational purposes only and is not legal or tax advice. Trust and tax laws are complex and can change, and the consequences depend on the particular trust instrument and individual circumstances.
