A client from Manhattan recently came to my office. He had established a significant trust for his children years ago, intending for the assets to support them and their own families for generations. He wanted to give his now-adult children some access to the funds for emergencies or opportunities, but without unraveling the entire structure he had so carefully built. “I want them to feel a sense of ownership,” he said, “but not control. I want them to learn stewardship.”
His goal is a common one. As custodians of our family’s legacy, we want to provide for our children, but we also want to protect them from mismanagement and tax burdens. This is where a specific provision, often called the “5 or 5 power,” becomes an incredibly useful tool in our work.
What is the “5 or 5 Power”?
The “5 or 5 power” is not a rule found in New York statutes, but a safe harbor created by the Internal Revenue Code—specifically, sections 2041(b)(2) and 2514(e). We incorporate this federal provision into the New York trusts we draft to achieve very specific goals.
The power gives a trust beneficiary the non-cumulative right to withdraw a certain amount from the trust each year. That amount is limited to the greater of $5,000 or 5% of the total trust principal. This is a limited withdrawal right—not an open door to the entire trust fund.
This specific limit is designed to work around the IRS’s definition of a “general power of appointment.” A general power of appointment is a broad right to direct trust assets to oneself, one’s creditors, or one’s estate. If a beneficiary holds such a power, the entire value of that trust can be included in their own taxable estate. The 5 or 5 power is an exception. It is a deliberate, limited power that does not trigger those significant estate tax consequences.
Tax Implications: The Power of the Lapse
The utility of the 5 or 5 power is most clear when a beneficiary doesn’t use it. Each year the beneficiary chooses not to withdraw the funds, that right for that year simply expires, or “lapses.”
Without the 5 or 5 safe harbor, the IRS would view this lapse as a taxable gift, arguing that by failing to take the money, the beneficiary effectively gave it back to the other trust beneficiaries. The 5 or 5 rule prevents this. It explicitly states that the lapse of this limited power is not considered a release of the power and is therefore not a taxable gift.
The result is two significant benefits:
- No Gift Tax: The beneficiary who lets their annual withdrawal right expire does not have to file a gift tax return or use their lifetime gift tax exemption.
- No Estate Tax Inclusion: Because the power is limited, the trust assets are not pulled into the beneficiary’s estate for tax purposes, except for the amount they could have withdrawn in the year of their death.
This aligns with definitions under New York’s Estates, Powers and Trusts Law (EPTL). EPTL § 10-3.2, for example, defines a general power of appointment. By carefully drafting a trust to use the federal 5 or 5 exception, we ensure the power granted to a beneficiary remains a “non-general” or “limited” one under the law, preserving the trust’s asset protection and tax advantages.
A Tool for Intentional Legacy Planning
The 5 or 5 power is more than a technical tax clause; it’s a flexible instrument for stewardship. We often use it in Irrevocable Life Insurance Trusts (ILITs) to help the grantor’s contributions to the trust qualify for the annual gift tax exclusion. It can also be built into dynasty trusts to give beneficiaries a predictable source of liquidity without handing over the keys to their entire inheritance.
It provides a measure of financial independence for a beneficiary. It allows them to access a modest amount of capital for a down payment, a business venture, or an unexpected expense, all while the core of the trust remains protected and invested for the long term. This is not about finding loopholes. It is about using established law to build a durable, multi-generational plan that balances support with prudence.
Thinking through these contingencies is the core of our work. It is how a legal document becomes a true reflection of a family’s values and intentions for the future.
If you have an existing trust or are considering creating one, the first step is a clear-eyed review of its provisions. We regularly perform trust document audits to identify how powers of appointment are defined and to explain their practical and tax consequences for trustees and beneficiaries. You can schedule one with our office to begin.
