Should You Fund Your 401(k) First or Your IRA?

Also, why we raised Cisco stock’s fair value estimate but not those for Kraft Heinz or Roku.

Feb 24, 2023

Should You Fund Your 401k First or Your IRA?

Ruth Saldanha: Vanguard’s hybrid ETF/mutual fund patent is expiring this year. How will this affect the fund market? Which retirement account should you fund first—your IRA or your 401(k)? Inflation can’t “ketchup” with Kraft Heinz sales for the fourth quarter. This is Investing Insights.

Welcome to Investing Insights. I’m your host, Ruth Saldanha. Let’s get started with a look at your Morningstar headlines.

Kraft Heinz Shares Are a Bargain

Corny puns aside, Kraft Heinz’s KHC fourth-quarter earnings report highlights why investors should add it to their shopping list. The company shook off inflationary pressure and supply chain disruptions to post organic sales growth of more than 10%. CEO Miguel Patricio stayed laser focused on cost-cutting and investing in the food and beverage giant’s brands—and as a result, sales sit 6% above 2019′s fourth quarter. The company’s category management and e-commerce efforts also were successful, and Kraft Heinz found $450 million in savings in fiscal year 2022. It says it will reinvest in the company. Morningstar is sticking with its $52 estimate of what the stock is worth and views shares as undervalued.

Roku Exceeds Q4 Expectations

Roku ROKU ended a challenging 2022 on a positive note. It reported higher fourth-quarter revenue than expected. A rush of new active accounts helped the streaming device company bring in $867 million in revenue. The quarter was one of the company’s strongest since the fourth quarter of 2020, which got a boost from the pandemic. Management expects first-quarter revenue to dip a bit versus the first quarter of 2022—and predicts positive adjusted cash flow before paying interest and taxes in 2024. Roku is still likely to lose money for a second straight year in 2023. It’s looking for new products to boost its international expansion, and while streaming hours improved year over year, platform revenue is down. Morningstar anticipates platform revenue growth to drop in 2023 due to the weak ad market. Morningstar maintains its $65 estimate of what it thinks Roku’s shares are worth.

Cisco Systems’ Core Networking Business Leads the Way

Cisco Systems CSCO reported a superb fiscal second quarter. Sales rose 7% year over year to $13.6 billion. The company’s core networking business led the way. Management noted strength in wireless but weakness in collaboration and security software due to pullbacks in spending. Cisco’s terrific guidance for the rest of the year reflects an improving supply environment and durably strong demand. Enterprise networking spending appears resilient against a backdrop of softening end markets elsewhere. This reinforces the long-term view that Cisco remains the pre-eminent heavyweight in this area. Cisco shows signs of improving its competitive position against rivals. Morningstar is raising its estimate of Cisco’s stock worth by $2 to $56 a share and sees value for long-term investors.

Vanguard’s Hybrid ETF/Mutual Fund Patent to Expire

Saldanha: Vanguard’s exchange-traded funds have a structure unlike any other ETFs available today. Many are share classes of its popular mutual funds, and at the moment, this hybrid ETF/mutual fund is unique to Vanguard because it owns a patent on the structure. But this patent is set to expire in May 2023. What will this mean for Vanguard, and the larger ETF space? Daniel Sotiroff is a senior manager research analyst for Morningstar Research Services, and he’s here today to tell us what he thinks. Daniel, thank you for being here today.

Daniel Sotiroff: Hey, Ruth, thanks for having me on.

Saldanha: In your opinion, what will be the likely impact of this patent expiring on the U.S. ETF and fund space?

Sotiroff: We’re in a little bit of a wait-and-see situation, I would say, but overall, I expect the impact’s going to be relatively small. For one, there’s only been one filing made to date, that covers seven mutual funds from Barrow Hanley, and that filing is still subject to SEC approval. They can put the filings out there, but the SEC still ultimately has to give its blessing on this at the end of the day.

But as we’ll talk about, the other thing to consider here is there’s trade-offs. This isn’t just a slam dunk where you instantly get this magic tax efficiency at the end of the day. There are some other things you’ve got to consider. And sort of along those lines, the number of mutual funds that I think actually qualify and are actually really good candidates for this, I think are relatively small in number.

Saldanha: How exactly does the structure work, and what are some of the benefits?

Sotiroff: Sure. The benefits are really a tax-efficiency play here. That’s really what you’re after. But maybe it’s best to just take a short step back here. If you think about what an ETF is, it’s really a mutual fund that trades on the stock exchange, and some of the mechanics that allow the ETF to actually trade on the exchange provide portfolio managers with a really valuable mechanism that allows them to get rid of taxable capital gains that are on their book.

What you end up with, all things equal at the end of the day, is the ETF is just a much more efficient wrapper for accessing a portfolio of stocks or bonds. Right? So the real winners here would be the investors in the existing mutual fund.

If you were to take this hybrid structure, you were to bolt an ETF onto an existing mutual fund, they would instantly have access to that ETF structure and the ability to get rid of their capital gains. So those are the real winners at the end of the day—potentially the existing investors in the mutual fund.

Saldanha: On the other hand, what are some of the disadvantages or drawbacks of this structure?

Sotiroff: I alluded to this in the previous answer: This isn’t just this instant magic fairy dust that you just sprinkle and the capital gains go away, right?

The thing you have to remember is that once you both bolt the ETF share class on, it’s going to take time for that ETF to actually purge those capital gains. The ETF is actually going to have to trade, it’s going to have to make some redemption in order to get rid of those potential capital gains. It’s not going to be instant. And along those lines, the ETF, as soon as it’s bolted on, it’s instantly exposed to any capital gains that are in the mutual fund.

If the ETF can’t get rid of those capital gains quickly, you could have some ETF investors that are on the hook for some capital gains at the end of the day.

The other thing you have to consider here is something that we call capacity management. Within the mutual fund structure, managers have the ability to actually shut their doors to new investors. So as they grow and they accumulate money, the risk they run into is that they may not be able to retain their edge in trying to beat the market or whatever their objective is. They may run out of their best ideas to actually invest in.

In those cases, we see good managers tend to shut their doors to preserve their edge. When you put an ETF share class onto a mutual fund, you kind of forfeit that because the ETF doesn’t really have a way of actually closing its doors. So for managers that have concerns about capacity management, this is just sort of a no-go for them.

Saldanha: Finally, what does this hybrid structure mean for investors, especially from a tax point of view?

Sotiroff: Yeah, the taxes are really the key thing to focus on here. If it’s done well and it’s executed correctly and you have the right candidates, the right funds that take this on, those mutual funds will be more tax-efficient in the long run. And it’s a win for investors at the end of the day, right? They get to choose when they take those capital gains as to when they sell out of the fund.

But that also gets us into the question, well, who would actually be a great candidate for this? Mutual funds that have tax losses on their books in the form of tax-loss carryforwards I think would be great candidates because that buys them some time to allow the ETF to get up to speed, build critical mass, to where it can start to handle those capital gains on its own.

You also would want to fund that isn’t in persistent outflows because if you have persistent outflows, that’s just going to make your tax situation more difficult to manage in the short run. And then funds that in the long run don’t really have concerns about capacity management, so you think of those broadly diversified funds, those big funds that are maybe mimicking the market with some modest advantages around the edges.

All of those characteristics combined are the funds that I think are going to be great candidates for this. Again, subject to SEC approval. So, we haven’t actually got the thumbs-up from the SEC yet on this whole thing, so we’ll wait and see.

But in the long run, I think if you’ve got some funds out there that meet those criteria, and they execute it well, and they handle this appropriately, this could be a good win for investors from a tax perspective. It could be a good thing at the end of the day.

Which Retirement Account Should You Fund First, Your IRA or Your 401(k)?

Saldanha: To save for retirement, most of us have multiple vehicles at our disposal, including IRAs and 401(k)s. The order in which we fund these accounts matters. To explain how this works, Morningstar’s director of personal finance Christine Benz spoke to Morningstar’s investment specialist Susan Dziubinski. Here’s what they had to say.

Susan Dziubinski: Hi, I’m Susan Dziubinski for Morningstar. Many of us have several vehicles at our disposal to use for saving for retirement, including 401(k)s and IRAs to name just two. How do we know which accounts to fund and in what order? Joining me to share some guidance on the issue with Christine Benz. She is Morningstar’s director of personal finance and retirement planning.

Nice to see you, Christine. Thanks for being here.

Christine Benz: Susan, it’s great to see you.

Dziubinski: So, let’s start out with some stage setting. Most people, when they are working, have multiple accounts that they have at their disposal that they could be using to save for retirement. Let’s walk through some of the most common ones that most people or many people have.

Benz: Right. And I’ll just say I love that you’re tackling this topic because I think this topic of household capital allocation is so underdiscussed. People just kind of wing it. We spend a lot of time talking about investment allocation. But how do we allocate our household capital? The key things in the toolkit would be a couple that you mentioned: your company retirement plan, assuming you have one available to you; IRAs would be another option; and you might also look at a taxable brokerage account, where you wouldn’t earn the same tax incentives to make those contributions, but there’s still some tax benefits, which we can touch on. And then there are sort of ancillary vehicles that someone could use. The big one in my mind is a health savings account, which is not a retirement account per se, but it’s something that you can bring into the mix as you’re thinking about retirement funding.

Dziubinski: Is there a hierarchy among those accounts that people should be using to decide which to fund first? Where should you start?

Benz: Right. I think a good spot to look at would be to take a look at your company retirement plan and find out if you’re earning any matching contributions from your employer. Because, as people have probably heard a million times, that’s free money. But seriously, you want to put in at least enough to earn those matching contributions. Households that are just getting started, I would say focus on your emergency fund and focus on making sure you’re earning the matching contribution. Start there.

Dziubinski: Next, you actually think a health savings account is a great second place to be looking at for retirement savings. And as you pointed out, that’s not technically a retirement savings vehicle. Tell us about why it ranked so highly, what you like about it, and who can use it.

Benz: Right. It’s important to discuss who can use it first. You need to be covered by a high-deductible healthcare plan. It needs to be a qualified high-deductible healthcare plan. And so, if you are covered by such a plan, if that’s your type of healthcare coverage, you can also use what is called a health savings account, and the tax benefits are better than anything else. You’re putting in pretax contribution, so you’re not getting taxed on the funds going in. You are earning tax-free compounding on your money, so no taxes due as long as the money stays inside the confines of that account. And then, assuming that you are pulling the funds out for qualified healthcare expenses, you can avoid taxes on those distributions as well. So, tax benefit at every step of the way.

And then, another thing I would say is that there’s actually some flexibility around the distribution. Once you hit age 65, you can pull the funds out as you would with a traditional tax-deferred IRA. So, it’s, I think, a valuable account, especially if you’re covered by a high-deductible plan, you want to set aside those funds to cover your healthcare expenses as you would incur them, but it’s also something valuable to carry into retirement.

Dziubinski: Step number three, once you’ve looked at that HSA if you can contribute to that and you’ve matched your employer contributions on your retirement plan, what’s next?

Benz: Look at a Roth IRA. And there are a couple of key advantages. One is that even though you’ll put in aftertax dollars, you’ll be able to enjoy tax-free withdrawals in retirement. The other key advantage, and the reason I really like to talk about Roth IRAs for people who are getting their plans off the ground, is that you have a lot of flexibility in terms of those contributions. So, you’re able to pull the contributions out, not the investment earnings, but the contributions out without any taxes or penalties for any reason. And so, it’s a nice backup emergency fund, even though you might have the best of intentions to leave the funds in there and to get them growing for retirement, you do have a fair amount of flexibility to pull the funds out earlier.

Dziubinski: And then, after the Roth IRA, let’s say, you still are fortunate enough to have assets that you want to be investing for retirement. Where do you look next?

Benz: Definitely do your due diligence on that company retirement plan. Go get the matching contributions regardless, it can be a really crummy plan, still contribute to it enough to earn the match. But if you want to put additional funds into the plan and you have them to invest, do your homework on the quality of the plan. So, you’re looking at investment options. That’s really the most transparent part of most plans. Do your homework on how much you’re paying in fees on those investment options. Then do a little bit of sleuthing on any administrative expenses that you’re on the hook for. If you work for a very large employer, chances are those will be nice and low. Smaller employers unfortunately tend to field higher-cost plans. Try to get your arms around what those administrative costs are. It’s hard to give a ballpark figure that is sort of a red flag, but I would say if you’re seeing administrative expenses over 0.5%, that’s a signal that you’ve got a high-cost plan. And unfortunately, you oftentimes see high-cost investment options to go along with that high administrative fee. So, in that case, you may want to use your funds, invest your funds elsewhere. But for many folks, especially folks with bigger plans, it’s a really good option to invest in that low-cost 401(k) plan.

Dziubinski: Let’s say you are in that boat where you’ve investigated the plan and either your options in that plan are high-cost and subpar or the whole plan itself is high cost, what do you suggest then?

Benz: Here, you would look to a taxable brokerage account. And so, the advantage of the taxable brokerage account, even though you’re putting aftertax dollars in, is just flexibility that you can decide whatever you want to put the money into. I guess that can be a double-edged sword. You could pick something crazy, but you have that flexibility in what to invest in. You can invest at any amount. There are no income limits on how much you can put into a taxable brokerage account, no contribution limits. So, just a ton of flexibility. And then, even though you’re putting aftertax dollars into the plan, so you’re not earning a tax break on your contributions, you have the potential to earn capital gains treatment when you pull the funds out for whatever your plan is for those dollars. Capital gains taxes are typically lower than the ordinary income taxes that would apply to, say, withdrawals from a traditional IRA or a traditional 401(k).

Dziubinski: And then, lastly, let’s talk a little bit to this group that you call super savers. Who qualifies as a super saver to start, and then what do you suggest for this cohort?

Benz: Right. So, for people who have maxed out, say, their IRA contributions, maybe their HSA, they’ve also maxed out their 401(k), their company retirement plan up to the limits, they want to be aware of what are called aftertax 401(k) contributions. Not all plans offer them. Bigger plans are increasingly offering this feature. But the idea is that you are making aftertax contributions. You’re contributing aftertax funds. And many plans offer what’s called an in-plan conversion feature. So, it’s a way to make that contribution of aftertax dollars and then almost immediately thereafter convert those dollars to a Roth 401(k). So, it’s a really nice option. If you are a heavy saver and you work for a large employer, check this out. See if it’s an option. If it’s not an option, lean on your administrator to investigate whether your plan could potentially include this option because it’s a really nice way for higher-income folks to save additional funds and earn tax-free withdrawals in retirement.

Dziubinski: Christine, thank you for your time today and for providing this framework for retirement savings. We really appreciate your time.

Benz: Thank you so much, Susan.

Dziubinski: I’m Susan Dziubinski with Morningstar. Thanks for tuning in.

Saldanha: Thank you, Susan and Christine! That’s all for this week’s episode. Don’t forget to subscribe to Morningstar’s YouTube channel to see new videos about market news, personal finance, and investment picks. Thanks to podcast producer Jake Vankersen who puts this show together. I’m Ruth Saldanha, an editorial manager at Morningstar. Thank you for tuning into Investing Insights.