Why put money in a Tax deferred 401k if Taxes will be higher in the future?

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masonstone
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Why put money in a Tax deferred 401k if Taxes will be higher in the future?

Post by masonstone » Tue Jun 04, 2019 11:18 am

Does it make sense to put money in a tax deferred account as compared to paying the Taxes now and getting the taxes over with?

Assume you're in the highest tax bracket with a 7 figure income.
Last edited by masonstone on Tue Jun 04, 2019 4:15 pm, edited 1 time in total.

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Re: Why put money in a Tax deferred 401k if Taxes will be higher in the future?

Post by MotoTrojan » Tue Jun 04, 2019 11:22 am

Option 1: Pay 25% tax now and pay 50% on all gains (let’s ignore dividends and that tax drag)

Option 2: Pay no tax now, and 50% on all withdrawals.

With any reasonable amount of growth it’s clear that option 2 wins since option 1 has a double tax on gains (smaller starting point). Dividend tax drag makes option 1 even worse. If cap gains remain a reduced tax rate, that changes the balance so perhaps make your own assumptions on taxes and growth and see how they compare.

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Re: Why put money in a Tax deferred 401k if Taxes will be higher in the future?

Post by anon_investor » Tue Jun 04, 2019 11:24 am

OP are you comparing 401k vs Roth 401k OR 401k vs taxable account?

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Re: Why put money in a Tax deferred 401k if Taxes will be higher in the future?

Post by jbranx » Tue Jun 04, 2019 4:12 pm

Topic is unlocked following Moderator review. Please keep in mind that this is a strict "no politics" forum. Discussions of proposed changes to existing legislation are off-topic. Here's why: Political comments and proposed tax plan remain off-topic

The main point is that you should invest according to current law. When the law changes, adjust your approach at that time.

An explanation of the difference between proposed legislation and proposed regulations is in this post.

Also remember that tax law changes revert in 2025.

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Re: Why put money in a Tax deferred 401k if Taxes will be higher in the future?

Post by greg24 » Tue Jun 04, 2019 4:17 pm

A bird in hand is worth two in the bush.

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Re: Why put money in a Tax deferred 401k if Taxes will be higher in the future?

Post by masonstone » Tue Jun 04, 2019 4:17 pm

MotoTrojan wrote:
Tue Jun 04, 2019 11:22 am
Option 1: Pay 25% tax now and pay 50% on all gains (let’s ignore dividends and that tax drag)

Option 2: Pay no tax now, and 50% on all withdrawals.

With any reasonable amount of growth it’s clear that option 2 wins since option 1 has a double tax on gains (smaller starting point). Dividend tax drag makes option 1 even worse. If cap gains remain a reduced tax rate, that changes the balance so perhaps make your own assumptions on taxes and growth and see how they compare.
Wouldn't the actual comparison be more like:

Option 1: Pay 40% tax now and pay 20% of all gains
Option 2: Pay no tax now and pay 40% of all withdrawals?

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Re: Why put money in a Tax deferred 401k if Taxes will be higher in the future?

Post by mchampse » Tue Jun 04, 2019 4:23 pm

On any money you are deferring, you are saving 37% as that is your marginal tax rate right now. Upon retirement, assuming social security and 401k/IRA are your only sources of earned income the money comes out at blended rates. The first few dollars coming out aren’t taxed, after that money is taxed at 10%, then 12%, etc.

That all said, I’m personally convinced that the Roth options are better for me and likely a large number of other people. If you can contribute the max, you effectively get to contribute more as a Roth since it comes out tax free.

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Re: Why put money in a Tax deferred 401k if Taxes will be higher in the future?

Post by MotoTrojan » Tue Jun 04, 2019 4:25 pm

masonstone wrote:
Tue Jun 04, 2019 4:17 pm
MotoTrojan wrote:
Tue Jun 04, 2019 11:22 am
Option 1: Pay 25% tax now and pay 50% on all gains (let’s ignore dividends and that tax drag)

Option 2: Pay no tax now, and 50% on all withdrawals.

With any reasonable amount of growth it’s clear that option 2 wins since option 1 has a double tax on gains (smaller starting point). Dividend tax drag makes option 1 even worse. If cap gains remain a reduced tax rate, that changes the balance so perhaps make your own assumptions on taxes and growth and see how they compare.
Wouldn't the actual comparison be more like:

Option 1: Pay 40% tax now and pay 20% of all gains
Option 2: Pay no tax now and pay 40% of all withdrawals?
Not sure what I can say that will prevent moderators from re-locking but just as the current delta between income-tax and long-term gains isn't set in stone, the existence of capital gains treatment isn't either. I specifically said above "If cap gains remain a reduced tax rate", so the real moral is to make a simple calculator and see what happens. Over any long time periods though and current tax law, you'd be hard pressed to find a situation where you don't come out ahead with pre-tax due to the growth on the untaxed amount and the lack of dividend tax-drag, even if the pure gains are taxed at a higher rate.

Even so, looking at your example which would you prefer, ignoring dividends?

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Re: Why put money in a Tax deferred 401k if Taxes will be higher in the future?

Post by retiredjg » Tue Jun 04, 2019 4:26 pm

masonstone wrote:
Tue Jun 04, 2019 11:18 am
Does it make sense to put money in a tax deferred account as compared to paying the Taxes now and getting the taxes over with?

Assume you're in the highest tax bracket with a 7 figure income.
If you make $1 million a year, I doubt that putting a little of it in a tax-deferred account is going to matter much either way.

For an ordinary earner in the highest tax bracket, there is every reason to believe that person's tax rate could be lower in retirement than while working. Being wealthy is not the same as having a high taxable income. In fact, one could have a very low income while being wealthy.

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Re: Why put money in a Tax deferred 401k if Taxes will be higher in the future?

Post by mchampse » Tue Jun 04, 2019 4:33 pm

MotoTrojan wrote:
Tue Jun 04, 2019 11:22 am
Option 1: Pay 25% tax now and pay 50% on all gains (let’s ignore dividends and that tax drag)

Option 2: Pay no tax now, and 50% on all withdrawals.

With any reasonable amount of growth it’s clear that option 2 wins since option 1 has a double tax on gains (smaller starting point). Dividend tax drag makes option 1 even worse. If cap gains remain a reduced tax rate, that changes the balance so perhaps make your own assumptions on taxes and growth and see how they compare.
Assuming that tax rules/rates remain similar, the tax on gains on option 1 would be 15% or 20% assuming it’s entirely capital gains. The tax on option 2 assuming 401k/traditional IRA is your only income would be 0 until you hit the standard/itemized deduction, 10% until you get out of the lowest bracket, etc.

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Re: Why put money in a Tax deferred 401k if Taxes will be higher in the future?

Post by livesoft » Tue Jun 04, 2019 4:45 pm

We know taxes will be higher for people in the highest income bracket in the future because that is current tax law with the 2018 tax law expiring for individuals after 2025.

So, Roth 401(k) could easily be the way to go for the OP.
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Re: Why put money in a Tax deferred 401k if Taxes will be higher in the future?

Post by TomatoTomahto » Tue Jun 04, 2019 4:55 pm

retiredjg wrote:
Tue Jun 04, 2019 4:26 pm
masonstone wrote:
Tue Jun 04, 2019 11:18 am
Does it make sense to put money in a tax deferred account as compared to paying the Taxes now and getting the taxes over with?
Assume you're in the highest tax bracket with a 7 figure income.
If you make $1 million a year, I doubt that putting a little of it in a tax-deferred account is going to matter much either way.
For an ordinary earner in the highest tax bracket, there is every reason to believe that person's tax rate could be lower in retirement than while working. Being wealthy is not the same as having a high taxable income. In fact, one could have a very low income while being wealthy.
Retiredjg, I can count on my thumb how often I disagree with you, and this is that time. I agree that the difference won’t be colossal, and that OP didn’t describe the situation thusly, but still, if your motivation is bequest driven, and/or you live in a state that has rough estate taxes and a low lifetime exclusion (or you think the federal lifetime exclusion will change/revert), and/or you assess tax rates being higher in the future as more likely than lower tax rates in the future, and/or you currently file MFJ and have reason to expect that one partner will live longer than the other, I think that consideration should be given to Roth.
Okay, I get it; I won't be political or controversial. The Earth is flat.

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Re: Why put money in a Tax deferred 401k if Taxes will be higher in the future?

Post by TomCat96 » Tue Jun 04, 2019 5:01 pm

One advantage I like about the tax deferred 401k, especially for those who are younger is the option to take out funds from a 401k at the expense of an early withdrawal penalty.

Obviously this is a suboptimal strategy. It must be avoided if it can be avoided.

Nevertheless,

Person A Earns income around 100k+, and is in the 24% federal tax bracket. Tax deferred contributions cause her to avoid a 24% tax rate.

Person A loses their job, earning little to no income the following year, placing them in a low tax bracket.
Person A may take out a portion of their 401k paying the early withdrawal penalty, and potentially paying an overall lower tax rate than the 24% avoided.

In such a scenario, it is possible that person A comes out ahead having a higher as-yet-untaxed amount in their portfolio 401k than a lower already taxed amount. (roth) Person A has more to draw from than Person B, who placed their funds in a roth vehicle.
Last edited by TomCat96 on Tue Jun 04, 2019 5:02 pm, edited 1 time in total.

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Re: Why put money in a Tax deferred 401k if Taxes will be higher in the future?

Post by WhiteMaxima » Tue Jun 04, 2019 5:01 pm

You can plan for the future such as early retirement, do Roth rollover so your future tax is lower than today. By saving more tax now and paying less tax in the future, you can be financial independent much earlier in the future.

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Re: Why put money in a Tax deferred 401k if Taxes will be higher in the future?

Post by MotoTrojan » Tue Jun 04, 2019 5:11 pm

mchampse wrote:
Tue Jun 04, 2019 4:33 pm
MotoTrojan wrote:
Tue Jun 04, 2019 11:22 am
Option 1: Pay 25% tax now and pay 50% on all gains (let’s ignore dividends and that tax drag)

Option 2: Pay no tax now, and 50% on all withdrawals.

With any reasonable amount of growth it’s clear that option 2 wins since option 1 has a double tax on gains (smaller starting point). Dividend tax drag makes option 1 even worse. If cap gains remain a reduced tax rate, that changes the balance so perhaps make your own assumptions on taxes and growth and see how they compare.
Assuming that tax rules/rates remain similar, the tax on gains on option 1 would be 15% or 20% assuming it’s entirely capital gains. The tax on option 2 assuming 401k/traditional IRA is your only income would be 0 until you hit the standard/itemized deduction, 10% until you get out of the lowest bracket, etc.
Yup that’s even more favorable. I was illustrating how even an extreme with no cap gains treatment could still win.

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Re: Why put money in a Tax deferred 401k if Taxes will be higher in the future?

Post by LadyGeek » Tue Jun 04, 2019 5:25 pm

This thread is now in the Investing - Theory, News & General forum (general question).
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Re: Why put money in a Tax deferred 401k if Taxes will be higher in the future?

Post by retiredjg » Tue Jun 04, 2019 5:32 pm

TomatoTomahto wrote:
Tue Jun 04, 2019 4:55 pm
retiredjg wrote:
Tue Jun 04, 2019 4:26 pm
masonstone wrote:
Tue Jun 04, 2019 11:18 am
Does it make sense to put money in a tax deferred account as compared to paying the Taxes now and getting the taxes over with?
Assume you're in the highest tax bracket with a 7 figure income.
If you make $1 million a year, I doubt that putting a little of it in a tax-deferred account is going to matter much either way.
For an ordinary earner in the highest tax bracket, there is every reason to believe that person's tax rate could be lower in retirement than while working. Being wealthy is not the same as having a high taxable income. In fact, one could have a very low income while being wealthy.
Retiredjg, I can count on my thumb how often I disagree with you, and this is that time. I agree that the difference won’t be colossal, and that OP didn’t describe the situation thusly, but still, if your motivation is bequest driven, and/or you live in a state that has rough estate taxes and a low lifetime exclusion (or you think the federal lifetime exclusion will change/revert), and/or you assess tax rates being higher in the future as more likely than lower tax rates in the future, and/or you currently file MFJ and have reason to expect that one partner will live longer than the other, I think that consideration should be given to Roth.
Well, save your thumb because we don't really disagree. :happy

I missed the original post. All I know is income is at or over $1 million a year and the question seemed to be whether to use tax deferral or not. I don't see any reason not to. And I don't see any reason to use tax-deferral either. There is not enough info in the two lines that remain of the original post to actually have an opinion.

It is possible for this person to be in a much lower tax bracket in retirement. That would argue for tax-deferral. But a person making that much money could easily just put the money in Roth and call it good. This might be optimal for heirs.

My only point is that it does not matter if tax rates go back up....the poster could still be in a lower bracket in retirement. Too many people think that being rich means having a high tax bracket. It just is not so.

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Re: Why put money in a Tax deferred 401k if Taxes will be higher in the future?

Post by TomatoTomahto » Tue Jun 04, 2019 5:37 pm

retiredjg wrote:
Tue Jun 04, 2019 5:32 pm
Well, save your thumb because we don't really disagree. :happy
Well, that's a relief :D

Just for the sake of completeness, in my litany of considerations that might argue against a t401k, I want to add that for some people, either due to temperament, the fact that "it's too late," or as often happens with highly compensated individuals, the pension and/or deferred compensation will be significant, low income during early retirement isn't an option, so Roth conversions don't come into the picture.
Okay, I get it; I won't be political or controversial. The Earth is flat.

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Re: Why put money in a Tax deferred 401k if Taxes will be higher in the future?

Post by zaboomafoozarg » Tue Jun 04, 2019 8:16 pm

This post could've also been:

"Why not put money in a Tax deferred 401k if Taxes will be lower in the future?"

Who knows what direction they are going to go? And how can a person take action on something they don't know will happen?

This is why I split traditional and Roth 50/50.

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Re: Why put money in a Tax deferred 401k if Taxes will be higher in the future?

Post by fyre4ce » Tue Jun 04, 2019 8:46 pm

masonstone wrote:
Tue Jun 04, 2019 11:18 am
Does it make sense to put money in a tax deferred account as compared to paying the Taxes now and getting the taxes over with?

Assume you're in the highest tax bracket with a 7 figure income.
Your question doesn't quite match the content of the post, without additional assumptions. If you're in the highest bracket now, then at maximum you can be in the highest bracket at withdrawal. For taxes (reading that as marginal tax rates) to be higher in the future, tax laws would have to change. Let's assume that top marginal rate goes back up to 39.6%, and is 37% today. Assume you have $25,000 of pre-tax income and you're trying to decide how to invest. Assume you invest in a stock mutual fund with a return of 9%, and a yield of 2%, of which 90% is qualified dividends and long-term capital gains, and you withdraw in 20 years.

Option 1: Tax deferred 401k
The entire $25k goes into the account.
It grows to $25k * (1 + 9%)^20 = $140,110.26
When withdrawn, you pay a 39.6% marginal tax rate, so the after-tax value is $140,110.26 * (1 - 39.6%) = $84,626.60

Option 2: Roth 401k
You pay a 37% tax rate on the money going in, so you are only able to contribute $25k * (1 - 37%) = $15,750
It grows to $15,750 * (1 + 9%)^20 = $88,269.47, and because it's Roth this is tax-free, this is the after-tax value.
Note the after-tax value is slightly more than option 1, due to the difference in marginal rates (37% vs 39.6%). If the marginal rates were equal, so would the Roth and tax deferred values.

Option 3: Taxable account
Taxable account math is a bit more complex but formulas are here: https://www.bogleheads.org/wiki/Taxable_account
Tax rates on non-qualified dividends are 37%, and 23.8% on qualified dividends. Average dividend tax rate is 90%*23.8%+10%*37% = 25.12%
You pay a 37% tax rate on the money going in, so you are only able to contribute $25k * (1 - 37%) = $15,750
The investment value grows to $15,750 * (1 + 9% - 2%*25.12%)^20 = $80,479.11
The basis grows to $15,750 + ($15,750 * 2% * (1 - 25.12%) / (9% - 2% * 25.12%)) * ( (1 + 9% - 2% * 25.12%)^20 - 1) = $27,157.73
After paying 23.8% capital gains tax, the after-tax value will be $80,479.11 - ($80,479.11 - $27,157.73) * 23.8% = $67,788.62

So, to answer your question of why to contribute to a tax-deferred 401k if you think/know tax rates will be higher in the future? You still end up with more money than investing in a taxable account, even if you never pay the 39.6% (or some other higher rate) on the taxable money. Although if you think/know/predict tax rates will be higher in the future, prefer Roth contributions over tax-deferred.

If you have the money in taxable, or cash flow, to pay the taxes, you could consider Roth conversions in accumulation phase if you think future tax rates will be as high or higher. Just don't do so much that you drop your tax-deferred money past the point of keeping you in the top bracket; doing this would mean you might pay a lower rate in the future than now. And keep in mind that the tax-deferred balance necessary to keep you in the top bracket in retirement is really high. You'd need around $600k per year at least in withdrawals, which is about $15M at a 4% withdrawal rate. If you expect to have more than $15M in tax-deferred in retirement, then Roth conversions down to this level might make sense.

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Re: Why put money in a Tax deferred 401k if Taxes will be higher in the future?

Post by bloom2708 » Tue Jun 04, 2019 9:06 pm

I avoid debt/paying interest.

I defer taxes whenever possible.

If I pay the same rate 30 years from now or 1% more or 2% more, I'll worry about that 30 years from now.

If I do pay the same or more, I will be alive. That is one win.

I do not have a pension. I will not have a pension. I can do Roth Conversions between work and SS if I really want to pay tax on the lowest tax brackets.

I might live in a no tax state or a state that doesn't tax withdrawals.

A VAT (Value Added Tax) might be in place by that time. The future is unknown so I will defer tax on $19k and put $6k into each of our Roth IRAs and defer tax on $7k of HSA contributions each year.
Last edited by bloom2708 on Tue Jun 04, 2019 9:07 pm, edited 1 time in total.
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Re: Why put money in a Tax deferred 401k if Taxes will be higher in the future?

Post by LadyGeek » Tue Jun 04, 2019 9:06 pm

fyre4ce wrote:
Tue Jun 04, 2019 8:46 pm
Your question doesn't quite match the content of the post, without additional assumptions.
Your comparisons of Option 1 and Option 2 are accurate, but might miss an important point: A Roth 401(k) is considered a sub-account of a 401(k) plan.

Translation: The combined contributions to both the Roth and Traditional components of a 401(k) account can't exceed the total IRS limits ($19,000 + $6,000 catch-up in 2019).

Here's a helpful calculator: Roth 401(k) vs. Traditional 401(k) Calculator Expand the "Investment return and taxes" section and move the sliders for the current and retirement tax rates. What happens when the current rate is higher? What happens when the retirement rate is higher? It drives the point home.

(The OP has not mentioned a Roth 401(k) contribution, these are assumptions used as examples.)
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Re: Why put money in a Tax deferred 401k if Taxes will be higher in the future?

Post by adamthesmythe » Tue Jun 04, 2019 9:50 pm

> Why put money in a Tax deferred 401k if Taxes will be higher in the future?

Because maybe they won't be?

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Re: Why put money in a Tax deferred 401k if Taxes will be higher in the future?

Post by michaeljc70 » Tue Jun 04, 2019 10:00 pm

retiredjg wrote:
Tue Jun 04, 2019 4:26 pm
masonstone wrote:
Tue Jun 04, 2019 11:18 am
Does it make sense to put money in a tax deferred account as compared to paying the Taxes now and getting the taxes over with?

Assume you're in the highest tax bracket with a 7 figure income.
If you make $1 million a year, I doubt that putting a little of it in a tax-deferred account is going to matter much either way.

For an ordinary earner in the highest tax bracket, there is every reason to believe that person's tax rate could be lower in retirement than while working. Being wealthy is not the same as having a high taxable income. In fact, one could have a very low income while being wealthy.
This. The deferred account maxes are low compared to your income.

One other consideration which I don't know if it was mentioned (I didn't read every post) was if you die and someone else inherits all/part of the tax deferred account it may be taxed at a different rate.

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Re: Why put money in a Tax deferred 401k if Taxes will be higher in the future?

Post by jdilla1107 » Tue Jun 04, 2019 10:17 pm

adamthesmythe wrote:
Tue Jun 04, 2019 9:50 pm
> Why put money in a Tax deferred 401k if Taxes will be higher in the future?

Because maybe they won't be?
And more importantly, maybe they won't be for your personal situation. It doesn't really matter what happens with the general level of taxes, only your own situation.

Will you be making 7 figures in retirement?

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Re: Why put money in a Tax deferred 401k if Taxes will be higher in the future?

Post by cherijoh » Thu Jun 06, 2019 12:21 pm

retiredjg wrote:
Tue Jun 04, 2019 4:26 pm
masonstone wrote:
Tue Jun 04, 2019 11:18 am
Does it make sense to put money in a tax deferred account as compared to paying the Taxes now and getting the taxes over with?

Assume you're in the highest tax bracket with a 7 figure income.
If you make $1 million a year, I doubt that putting a little of it in a tax-deferred account is going to matter much either way.

For an ordinary earner in the highest tax bracket, there is every reason to believe that person's tax rate could be lower in retirement than while working. Being wealthy is not the same as having a high taxable income. In fact, one could have a very low income while being wealthy.
If you are talking about someone making 7-figures and participating in a 401k as an employee only, then I agree with retiredjg - the amount you can save in tax-deferred is peanuts in the big picture (unless your employer has generous matching or makes a contribution independent of the employee's participation). Of course if you are an owner or partner, you may have some influence on the employer contribution level too.

But if you are making 7 figures, you could also be planning to retire very early - even decades before you would be subject to RMDs. In that case, you are probably also saving a bundle in taxable accounts that can be spent down but generate a lot less taxable income. You might have opportunities to do Roth conversions on whatever you managed to save in tax-deferred before RMDs and SS kick in without triggering increased marginal tax rates if the conversions are spread out over time.

IMO, early retirees who maxed out tax-advantaged accounts (and save the equivalent amount of deferred taxes in a taxable account) have a good chance of being able beat someone who just maxed their Roth accounts and saved nothing in taxable in terms of total lifetime taxes. Of course this requires they had a good plan for executing Roth conversions.

Similarly, DINKs (dual income no kids) who were planning on a family and a one-income household in the future, might consider using traditional now and doing Roth conversions when their marginal tax rate has dropped. I ended up going back to school after a job loss (and working part-time) and was able to take leverage lower marginal tax rates to do Roth conversions. Some of which also corresponded with the Great Recession.

It isn't always a given that everybody will always have the same or higher marginal tax bracket that they do in their prime earning years. YMMV.

Of course many people who are already retired (or soon to retire) never had the opportunity to save much directly in Roth so their choice was between traditional vs. taxable (not traditional vs. Roth). And prior to the last 15 years or so, for many people that meant investing in actively-managed MF - some of which had tax-adjusted returns considerably lower than gross returns due to large capital gains distributions. :annoyed

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