Abroad in America

The 5-Year Rule That Could Cost Expats Thousands

• Jimmy Miller

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Many expats working in America contribute to a traditional 401(k) because it lowers their taxes today.

But what happens if you later realize that decision could create tax complications when you leave the United States?

In this episode of Abroad in America, we explore one of the most powerful retirement planning tools available to expats: the Roth conversion.

A Roth conversion allows you to move money from a traditional pre-tax retirement account into a Roth account, potentially creating greater tax flexibility and reducing future dependence on the U.S. tax system.

We discuss why Roth conversions can be especially valuable for expats, how the strategy works, and why understanding the Roth five-year rules is critical before making any decisions.

You'll learn the difference between the Roth earnings five-year rule and the Roth conversion five-year rule, how a Roth conversion ladder works, and why thoughtful tax planning can help you avoid costly mistakes.

We also cover common Roth conversion traps, including converting too much in one year, overlooking state taxes, paying conversion taxes incorrectly, and failing to consider how your home country may treat Roth accounts.

If you've already accumulated money in a traditional 401(k) and are wondering whether you still have options, this is an episode you won't want to miss.

In This Episode

• What a Roth conversion is and how it works
• Why traditional 401(k) accounts can create challenges for expats
• The difference between paying taxes now versus later
• Why Roth conversions can create more flexibility for globally mobile professionals
• How Roth accounts can reduce future tax uncertainty
• Why converting everything at once is often a mistake
• The difference between the Roth earnings five-year rule and the Roth conversion five-year rule
• How the Roth conversion five-year clock works
• Why converted principal and investment growth are treated differently
• How a Roth conversion ladder strategy works
• A real-world example of using Roth conversions over multiple years
• How to evaluate whether your employer's retirement plan allows conversions
• Why paying conversion taxes from outside assets is often preferable
• The importance of tracking multiple conversion clocks
• Common Roth conversion mistakes expats should avoid
• Why cross-border tax planning matters before leaving the United States

What's Coming Next

• Managing retirement accounts after leaving America
• Cross-border retirement planning strategies
• Tax considerations for Americans and foreign nationals abroad
• How different countries treat Roth accounts
• Additional ways expats can create tax-efficient retirement income

A traditional 401(k) doesn't have to become a permanent tax problem. With proper planning, Roth conversions may help you create greater flexibility, reduce future tax uncertainty, and build a retirement strategy that better fits a life lived across borders.

SPEAKER_00

Welcome to the Lord in America Podcast. The only financial podcast designed specific experts living in America. Where you go behind the scenes with financial planner, author, and speaker, Jimmy Miller, to learn how to make your time in America. And now here's your host, Jimmy Miller.

SPEAKER_01

Hey everyone, welcome back to Abroad in America. I'm your host, Jimmy Miller. In the last episode, we talked about why expats working in America should usually think very seriously about contributing to the Roth 401 instead of the traditional pre-tax 401 at work. The basic idea was simple. The traditional 401 gives you a tax break today, but creates a tax bill later. And it's really just like borrowing money from the IRS. The Roth 401 makes you pay tax today, but can give you much more flexibility later, especially if you're planning to leave the United States and take your money with you. But today we're answering the obvious follow-up question. What if you already made the wrong choice? What if you've been in America for a few years and you chose the traditional 401k back when you started your job? Maybe because HR told you it would save you taxes, or because everyone else did it, or because you had no idea there was another option. Are you stuck? No. You may still have a way to fix it, or at least improve the situation dramatically. And that strategy is called a Roth conversion. Today we're going to talk about what the Roth conversion is and how they can help expats and why the five-year rule is one of the most important rules to understand before you use the strategy. But first, let's quickly reset the problem. When you contribute to a traditional 401k, the money goes in before tax. That means you get a tax break now, and that feels good. You look at your paycheck and you think, wonderful, I saved a little money from the IRS. But as I said in the last episode, and as I talk about in my book, Divorce the IRS, you didn't really avoid the tax. You only delayed it till later. In other words, you took a little loan from the IRS. And one day, the IRS wants that loan repaid. When you eventually take the money out of a traditional 401k, the money is generally taxed as ordinary income, just like you made it at work. And if you take it out before age 59 and a half, you may also owe a 10% early withdrawal penalty on top of the regular income taxes. And this creates a big problem for expats. Because many expats don't move to America thinking, I'm going to retire here at 67 and spend the next 40 years following the exact U.S. retirement account rule book. Most expats are here for a chapter of their lives, maybe three, five, or ten years, maybe longer than expected because life got complicated and America became home. But for many foreign nationals, there's a decent chance they'll eventually leave. And when that happens, the traditional 401k can become a suitcase full of tax problems. You may look at the account and think, great, I've saved $80,000. But the IRS looks at it and says, excellent, we own part of that and we want our taxes. And if you're under $59.5 and you want to take the money out, the IRS will want to take an even bigger part of it with a 10% early withdrawal penalty. That's what we're trying to fix. Let's take a look at something called the Roth conversion. Now a Roth conversion is the process of moving money from a pre-tax retirement account into a Roth account. In simple terms, you're moving money from the tax me later bucket into the tax me never bucket. That's the whole strategy. You take money that has not been taxed yet, for example, money sitting in a traditional 401k or traditional IRA, and you convert it into a Roth or Roth IRA account or a Roth 401k account. But there's a catch. When you do the conversion, you will owe tax on the amount converted. So if you convert $20,000 of pre-tax money into a Roth IRA, that $20,000 generally gets added to your taxable income for that year. And that's the painful part. But once the tax is paid, that money has changed character. It's no longer pre-tax money waiting to surprise you later. And remember, you were always going to pay the tax on that money, whether you did it now through a Roth conversion or later when you took the money out. But now it would be all Roth money, and that can be powerful. Think of it like paying the exit fee to leave the IRS partnership. You don't love paying it. Nobody throws a party because they created a tax bill for themselves. But sometimes paying a known tax today is better than carrying an unknown tax problem into the future, especially if your life may take you across borders. And you have to remember you were always going to pay that tax. I can't say that enough. It was just a matter of when. Better now on a smaller balance than later on a much bigger balance as well. For expats, Roth conversions can be especially useful because your life is mobile. You might move back home, you might move to another country, you might stay in America longer than planned, you might eventually become a permanent resident, but you might not. That's uncertainty. And uncertainty is exactly why tax flexibility matters. A traditional 401k keeps you tied to the US tax system. You may leave America physically, but your retirement account still has an American tax string attached to it. A Roth conversion can help cut that string or at least shorten it a lot. Instead of carrying a pre-tax account indefinitely, you can intentionally convert some of that money while you're still planning, still organized, and still able to make thoughtful decisions. The key word here is intentional. You don't usually want to convert everything all at once without thinking. That could push you into a much higher tax bracket and create a giant tax bill. Instead, many people convert strategically. A little this year, a little next year, maybe more in a year when your income is lower, maybe less in a higher income year, maybe in the year after you leave America and don't have any earned income. This is often an optimal time since your income in America will only be what you choose to Roth convert. This is tax planning, not tax panic. And for expats, it can become a way to clean up the traditional 401k mistake before leaving America, or at least before needing the money. Now let's talk about the star of today's episode, the five-year rule. Actually, let's make this more annoying. There is more than one five-year rule, because of course there is. This is America, and even the rules have rules. But for today, there are two five-year rules that I want you to understand. Rule number one is the Roth IRA earnings five-year rule. This rule applies to whether the growth in your Roth IRA can come out tax-free. Generally, for Roth IRA earnings to be part of a qualified tax-free distribution, you need to satisfy a five-year Roth clock and also meet another qualifying condition, which is usually being 59 and a half years old. This is the rule people often hear about when someone says your Roth needs to be open for at least five years. That rule matters, but it's not the main rule that we're focused on today. Rule number two is the Roth conversion five-year rule. This is the one that expats need to understand for conversions. When you convert pre-tax money into a Roth IRA, you pay the tax in the year of the conversion. But if you're under 59 and a half and you withdraw that converted money too soon, you may still owe the 10% early withdrawal penalty. Why is that, you ask? Well, because the IRS does not want people to do this. Step one, convert the pre-tax IRA money to Roth. Step two, take it out immediately. Step three, avoid the 10% early withdrawal penalty. You see, the IRS saw that coming, so they created a waiting period. Each Roth conversion generally has its own five-year clock, and that clock starts on January 1st of the year that you make the conversion. So if you convert money in November of 2026, the clock is treated as started on January 1st, 2026. This means the converted principal may become available without the 10% penalty after the five-year period is satisfied. That's the magic. It's not instant magic, kind of more like slow cooker magic, but magic nonetheless. This next part is really important, so let's slow it down a bit. When you convert pre-tax money to Roth, you pay tax on the converted amount that year. So if you convert $30,000 and pay the tax, that $30,000 is no longer waiting to be taxed again as ordinary income. But the growth on that money is different. Let's say you convert that $30,000 and five years later it has grown to $40,000. The original $30,000 is converted principal and it isn't taxed or penalized. You could take it out, no taxes or penalties. But the extra $10,000 is growth. The five-year conversion rule can help make the converted principal penalty free after the waiting period, but that doesn't automatically mean the growth is tax-free and penalty free if you're still under 59 and a half. The growth has its own Roth qualified distribution rules. So the simple way to remember this is converted principal gets one set of rules, growth gets another. Or even simpler, don't assume Roth means I can withdraw everything tomorrow with no consequences. That's how people get surprised. And not the good kind of surprise, like finding $20 in an old jacket, the bad kind, like finding an IRS form in your mailbox. Now let's talk about how expats might actually use this. A common strategy is sometimes called a Roth conversion ladder. And here's the idea you convert a portion of your pre-tax retirement money each year, and then you wait five years. After the five-year clock is satisfied, that converted principle may become available without the 10% early withdrawal penalty. Then on the next year's conversion, that will become available the year after that, and so on and so forth. Let's use an example. Imagine an expat named Sophia. Sophia moved to America for work and spent five years contributing to a traditional 401k. She now has $90,000 in that account. And after listening to this podcast, which is a great choice, Sophia, she realizes that having all of that money in a pre-tax account may not be ideal if she plans to leave America in a few years. So she talks with a cross-border tax advisor and decides not to convert the whole $90,000 in one year. Instead, she converts $30,000 this year. That $30,000 is added to her taxable income this year and she pays the tax from savings outside the retirement account. Next year, she converts another $30,000. The year after that, she converts the final $30,000. Now she has moved her traditional money into Roth over time. The first conversion has one five-year clock, the second conversion has another, and the third another yet. If she waits out each five-year period, the converted principal may become much more accessible than it would have been inside the traditional 401. That is the ladder. You're not trying to jump from the ground to the roof, you're just building steps, and for expats, steps matter, because your life may not follow the standard American retirement timeline. So how do you actually do this? First, stop making the problem bigger. If you're still contributing to a traditional 401 and your plan offers a Roth 401, consider switching future contributions to Roth. That doesn't fix the old traditional money, but it stops adding more dollars to the Tax Me Later bucket. Second, look at your existing pre-tax retirement money. If it's in your current employer's 401, you need to check what the plan allows. Some plans allow in-plan Roth conversions, meaning you may be able to convert traditional 401k money into Roth money inside the same plan. Other plans do not. If you've left the employer, you may be eligible to roll the traditional 401 into a traditional IRA and then convert from the traditional IRA to a Roth IRA, which works just as well. But please hear this clearly. Do not just click buttons and hope for the best. Retirement account mistakes can be expensive, especially when you're dealing with cross-border issues. Now third, decide how much to convert. And this is where tax planning matters. You may not want to convert so much that you push yourself into a much higher tax bracket. You may also need to think about state taxes, your visa status, your expected departure date, whether your home country recognizes Roth accounts, and whether your future country of residence may tax that account differently. And fourth, pay the tax from outside money if possible. Now this is a big one. If you're under 59 and a half and you use part of the retirement account itself to pay the tax, that tax withholding may be treated like a distribution. And that can trigger the very penalty you were trying to avoid. So ideally, you convert the full amount and pay the tax bill from cash savings or other non-retirement assets. That keeps more money inside the Roth and avoids sabotaging the strategy. Fifth, track the clocks. Every conversion needs a record. What year did you convert? How much did you convert? How much was taxable? When does the five-year clock end? This is not a strategy where you just want to rely on memory because five years from now you will not remember whether the conversion happened in February, November, or that year we moved apartments and everything was in chaos. Keep records. Your future self will thank you. Now, I like Roth conversions a lot, but they're not magic dust. They do need to be done correctly. And here are the big traps. Trap number one, converting too much in one year. A Roth conversion creates taxable income. Too much conversion income can push you into a higher tax bracket and make the strategy less efficient. Trap number two is forgetting about state taxes. If you live in a state with income tax, the conversion may create state tax too. This can matter a lot. Forty-three of the states in the United States have state income taxes. And trap number three, assuming your home country treats Roth accounts the same way America does, very few countries recognize Roth treatment. Most do not. Some tax Roth distributions differently. Some may treat the count in a way that surprises you. This is why cross-border tax planning matters before you leave. Now trap number four is withdrawing the growth too early. Remember, conversion principle and growth are not the same thing. Trap number five is waiting too long. The five-year rule requires time. If you wait until the month before you leave America and then try to create a perfect plan, your options are probably limited. This strategy works best when you start early. So here's the big takeaway. Episode six was about choosing the Roth 401k going forward. Episode 17 is about what to do if you already have money in the traditional 401k. And the answers may be to convert it. Not always, not all at once, and certainly not without planning. But for many expats, Roth conversions can be a smart way to take money that is trapped in the tax me later bucket and move it into the tax me never bucket. You pay the tax intentionally. You start that five-year clock. You give yourself more flexibility later. And most importantly, you stop pretending the traditional 401k balance is completely yours. Because until that tax is paid, it really isn't. The IRS is still sitting quietly in the passenger seat. A Roth conversion is one way to politely ask them to get out of the car. Not for free, of course, this is still the IRS. But once they're out, you may have a much cleaner, more flexible retirement account to take with you to the next chapter of your life. And for expats, that's the goal, not just saving money, saving money in a way that fits a life lived across borders. Now that's it for today's episode of Abroad in America. If you already have money in a traditional 400K, don't panic. You may still have options, but don't wait until the week before you move home to figure them out. Talk with a qualified cross-border tax professional and a fiduciary financial advisor who understands expats, Roth conversions, and the five-year rule. Because in America, it's not just about how much money you make, it's about how much money you actually keep. In the next episode, we'll discuss leaving your money invested in America when you leave. With technology today, it often makes sense and can be managed from anywhere.

SPEAKER_00

So until next time, stay curious, stay intentional, and as always, keep exploring.com. And subscribe to the blog to stay up to date on the 2015. Don't forget to subscribe and never miss an app. This podcast is designed for general education purposes only and shouldn't be taken as legal investment or tax advice. You should seek out a qualified tax professional or licensed financial advisor to determine what is best for your personal situation.