Inherited IRA Investors Get Another Break, but the Clock Is Ticking on RMDs

Ivanna Hampton: Here’s what’s ahead on this week’s Investing Insights. The IRS is giving people who inherited IRAs a break for another year. What this means for their required minimum distributions, taxes, and withdrawal timeline. Denise Appleby, aka The IRA Whisperer, will explain what you need to know. Plus, where Disney is seeing success for the first time and what’s holding the entertainment powerhouse back. And the market appears to be overlooking an undervalued opportunity to play the AI boom. I’ll talk with a Morningstar strategist about the sector he believes is not getting enough respect. This is Investing Insights.

Welcome to Investing Insights. I’m your host Ivanna Hampton. Let’s get started with a look at the Morningstar headlines.

Disney’s Improved Streaming Results

Walt Disney DIS showed improved streaming results during its fiscal second quarter. But Morningstar is concerned about the bigger picture. Disney’s entertainment streaming revenue grew 13% year over year. That excludes ESPN+. Entertainment streaming revenue also reached operating profitability for the first time. Disney announced an agreement with Charter Communications CHTR last year to distribute Disney’s traditional broadcast and streaming offerings to cable TV subscribers. The agreement took effect in January. Disney+ added a whopping 8 million US subscribers during the quarter as a result. But Morningstar views streaming as linked to traditional broadcast TV. Excluding ESPN, Disney’s broadcast TV revenue and operating income declined. Disney provided a muted outlook for its fiscal third quarter despite improvements in streaming. Morningstar believes performance will remain muted until Disney shows more progress in both streaming and traditional broadcast TV. Morningstar thinks Disney stock is worth $115 per share and fairly valued.

Uber’s Strong Financial Results in 2024

Uber UBER kicked off 2024 with strong financial results. The ride-hailing and delivery platform posted year-over-year growth in bookings, frequency, and profitability. Revenue rose to just over $10 billion. Performance could have been even greater, but Uber changed its business model in some markets. Gross bookings, or what a customer pays for rides and deliveries, rose 20% year over year. Uber’s freight segment’s struggles partially offset the increase. The company is gaining more value as more customers use its services. Users, trips, and average revenue per user all increased. Uber also showcased its ability to expand margins and increase revenue. Uber One is Uber’s subscription service. Its adoption remains solid with members and member retention also tracking up. Morningstar maintains that Uber’s stock is worth $80 and looks undervalued.

Palantir’s Performance Led by AI Platform

Palantir’s PLTR performance so far in fiscal 2024 is largely in line with Morningstar’s expectations. The tech company’s artificial intelligence platform led Palantir’s results. Morningstar thinks Palantir would benefit from increased AI spending as a leader in the AI platform space. First-quarter sales reached $634 million. Despite sales being lower than estimated, Morningstar is impressed by Palantir’s continued traction in the US commercial market. Morningstar believes this is a good sign for Palantir, because US companies are often early software adopters, with global markets following suit. Morningstar is also impressed with Palantir’s performance expectations. The tech company continues to expand its profitability with marked improvement in its margins. Palantir’s net retention, a measure of the firm’s ability to upsell existing customers, is turning around with growing adoption of its AI platform. Palantir also raised its outlook for 2024. Morningstar thinks that Palantir is still worth $16 per share. The stock appears overvalued.

Opportunities With Artificial Intelligence and Utilities Stocks

Some investors may be overlooking or even ignoring an undervalued opportunity to participate in the AI explosion. Your ears probably perked up, and you might’ve thought, “Tell me more.” Utilities stocks delivered impressive earnings in 2023, and dividends rose across the sector. So, why are stock prices stagnant? Travis Miller, an energy and utilities strategist for Morningstar Research Services, has written about this. Welcome back to the podcast, Travis.

Travis Miller: Thanks, Ivanna.

Utilities Stocks: When Will the Market Give the Sector Some Respect?

Hampton: Why do you think the market has not given the utilities sector its respect?

Miller: This is really cool to be here and talking about the utilities sector because we’ve got a generational change going on here in the sector. This is not something we’ve seen in 20 and 30 years, and let’s give it its due, toward artificial intelligence. These data centers that are coming up here take a lot of electricity. You’ve read the headlines, and the numbers are even greater than what we see in the headlines right now. Utilities are going to benefit, and it’s been a fun time here as we look forward.

Where Do Utilities Fit Into AI Growth?

Hampton: Many investors are paying a lot of attention to companies and sectors at the center or near AI. Where do utilities fit in this growth? You mentioned that it’s powering it. What else you got?

Miller: We’re just in the early stages here. We’ve heard a couple of announcements. I’ll just give you a couple of details here. Wisconsin is turning into a big data center hub. You wouldn’t think about the Midwest, but the Midwest is really a focus point here for a lot of these data center developers. So, to give you one number, Wisconsin Energy in Southeast Wisconsin, Microsoft MSFT just announced one project that’s under construction and the potential for three more.

That could increase Wisconsin Electric demand by 10%. Give you a sense there, Wisconsin Electricity demand’s grown 6% in the last 20 years. So, within five years we could more than double the growth in electricity demand just in Wisconsin. Another example, in Georgia, Southern Company SO, the largest utility in Georgia, just took their demand estimate up by almost 50% during the last two years.

Microsoft has six data centers there in the Atlanta suburbs, either in construction or planned. One more data point, these are coming in every day: In Mississippi, AWS [Amazon Web Services] AMZN announced a $10 billion project there for data centers. The largest industrial project in Mississippi state history. All of that’s going to need electricity.

How Higher-for-Longer Interest Rates Could Affect Utilities

Hampton: Thank you for the bonus. Let’s talk about how higher-for-longer interest rates could affect the sector. What do you think?

Miller: Yeah, interest rates have always been a key driver for utilities. Investors always saw utilities as dividends, dividend-paying stocks, and bond proxies, income stocks. What we think has changed in the last two years is this introduction of growth. We saw utilities trading a lot on interest rates over 2022 and 2023. The sector had its worst relative performance in 2023 in 25 years.

Utilities were down about 7%. The market was up about 26%. That performance, that relative performance hasn’t been so bad in, again, several decades. The reason for that is that the market was anticipating higher-for-longer interest rates. That was a big drag. What happened in October of last year is when the tide really shifted.

The market was still thinking higher interest rates, and they were still getting less bearish on bonds, but the tide turned when people started thinking about growth in the sector. This is when utilities started to rally. There got to be some of these growth overlays, and interest rates became a second thought here for utilities.

So since October, it’s pretty phenomenal. Utilities up 30%. Guess what the next best sector is? Technology. Utilities have performed just as well as the tech sector over the last six months, and a lot of that is because the growth element has started to come into the forefront of investors’ minds.

Utilities Stock Picks

Hampton: What stocks should investors consider?

Miller: I mentioned a couple of them just overall in terms of the data center development, but the two that we like right now are Entergy ETR. So. I mentioned the Mississippi data center project. Entergy serves Mississippi. They also serve Louisiana, parts of Texas. The key there is that’s a region where there are a lot of hurricanes that go through, a lot of natural disasters in some respects.

What these data centers want and what industrial customers’ manufacturing growth, what they want is reliability and resiliency. So, does the grid stay up? And when it does go down, can it come back? Utilities need a lot of investment in the system in that region to attract industrial customers and data center customers. Entergy is putting in that growth investment.

That yields over 4%. We think it can grow 7% earnings over the next five years at least, and probably a runway to 10 years or more. Another one is WEC Energy WEC. I mentioned the Wisconsin development with Microsoft. Again, one of our top picks because of all the growth investment that’s going to be needed in Southeast Wisconsin. So, another stock with 7%-type earnings growth. It’s going to yield just under 4% and really attractive growth that could go on beyond five years.

Hampton: Thanks, Travis, for coming to the table and sharing your insights about this growth sector.

Miller: Thanks for having me.

New Rules for Inherited IRAs

Hampton: Some rule changes for inherited IRAs have caused confusion. The Secure Act shrank some beneficiaries’ timeline for withdrawing money from retirement accounts they inherited. It dwindled from over their lifetime to 10 years. It also ruled that beneficiaries are required to take minimum withdrawals, or RMDs, every year, but the IRS keeps waiving the penalty if withdrawals aren’t taken, making the rule moot. What does this mean for investors and how can it affect their taxes? IRA Quick Reference Guide author and Morningstar contributor Denise Appleby has written about this. Welcome to the podcast, Denise.

Denise Appleby: I’m so glad to be here. Thanks for having me.

Withdrawals From Inherited IRAs and the 10-Year Rule

Hampton: How are the withdrawals from Inherited IRAs supposed to work and who is required to take out the money within 10 years?

Appleby: First of all, I’m so glad that you said the IRS waived the excise tax because you have done what many have not, and it’s to make the distinction that it’s the excise tax that is waived and not the required minimum distributions. Let’s talk about how we got here. When Secure Act 1.0 was signed into law, the language was very clear. It said if you are a plain designated beneficiary, you are subject to the 10-year rule. And the 10-year rule works like the old five-year rule. Under the old five-year rule, distributions were optional for the first four years. You got to empty the account by the end of year five.

When they tell you that the 10-year rule is exactly like that, except it’s 10 years, it’s reasonable to believe then that distributions were optional in all cases under the 10-year rule. But then when they published the proposed RMD regulations in February 2022, they said, “Not so fast. Don’t forget that the at-least-as-rapidly rule applies.” And under the at-least-as-rapidly rule, if you inherit an IRA from someone who was already taking RMDs, you can’t stop that train. You just got to hop on and continue taking RMDs.” Except that those RMDs would be over the beneficiary’s single life expectancy. If you inherit a traditional IRA from someone who was already taking RMDs, you have to continue taking RMDs, but you have 10 years to empty the account if you are just a regular designated beneficiary.

Important Distinction About What the IRS Waived in 2024

Hampton: Why is that distinction important? If someone is looking at it and they’re like, “I got this penalty I don’t have to pay, but this timeline is still going.” What should they know if they’re looking at this?

Appleby: They should know that in this case, the IRS has waived the excise tax, not the RMD. Let’s assume that you inherited your traditional IRA in 2020. Then you have to empty the account by the end of 2030, 10 years. But then the IRS acknowledged, “Listen, we agree. The language in Secure Act 1.0 is misleading. Now, normally, if you didn’t take your RMD as a beneficiary, we would ding you 50% of the amount that you should have taken, but you didn’t take. Now that 50% was reduced to 25%, effective 2023.” But when they published that, Ivanna, people said, “Listen, are you crazy? No, you’re telling me you confused me, and then I’m going to have to give you 50%. What’s wrong with this picture?” And the IRS said, “OK, OK, OK, we agree. We messed up. Here’s what we’re going to do. If you didn’t take it, we’re not going to charge you the 50% excise tax that you would owe otherwise.”

When they first applied this waiver or published the guidance about this waiver, it was for 2021 and 2022. Then later on they said, “Let’s extend it for 2023.” Now they have said, “Let’s extend it for 2024.” So, someone who inherited an IRA in 2020 still has the end of the 10-year period to take it. But if they took advantage of this provision and didn’t take it for 2021, 2022, 2023, 2024, they still only have six years to take it. This is a tax question now. Should you take advantage of that and not take your RMDs for those years? Because then you have six years over which you have to bunch up those distributions, which could mean larger distributions. That’s not a problem for everyone, which is why you want to talk to your tax advisor and say, “Does it make sense for me to work with that and not take the RMD for this year?” Maybe this is your last year that you’re working and getting that big fat paycheck and you retire next year, so it might make sense for you because you’re going to have less other income coming in.

One of the reasons why I thought it was important to make that distinction is when Congress waives RMDs, it adds an additional year to people who were subject to the five-year rule under the old rules. If they had waived RMDs under this provision, let’s say they had waived it for 2024, then anyone who was subject to the 10-year rule would’ve gotten an additional year. Also, if they had waived RMDs and you had your money in an inherited 401(k) and you were rolling it over, then you could roll over the entire balance. But they didn’t waive RMDs. What that means is you still only have 10 years. If your account is an inherited 401(k), and you’re rolling it over to an inherited IRA, you have to take the RMD first because RMDs cannot be rolled over, which is two of the reasons why it’s important to make that distinction that it’s the excise tax that is waived and not the RMDs.

Tax Implications for Inherited IRAs

Hampton: Really getting into the taxes, if someone was thinking maybe they inherited an IRA in 2023 or 2024, and they’re like, “I got 10 years, or I could take it out yearly. I could do it in a lump sum.” What are the tax implications if you spread it out versus just doing it at one time?

Appleby: Exactly. That’s the conversation you’re going to have with your tax advisor, and you’re going to say, “Listen, based on my tax profile, if I spread this out evenly over 10 years, is it better for me? Or should I take only the minimum amount, then take what’s left in year 10?” Because here’s what happens. I see a lot of people get up in arms saying, “Oh no, I have to take RMDs.” That’s not necessarily a bad thing. Even if you take only the RMD each year, come year 10, you’re going to have a big balloon payment to take out at that time. So, the question becomes, how does that affect you from an income tax perspective? Because remember, the primary reason why we’re saving in these tax-deferred retirement accounts is to minimize the tax impact of our savings, and that extends to our beneficiaries, too.

Will the IRS Suspend the Withdrawal Penalty for Inherited IRAs in 2025?

Hampton: Now, 2024 marks the fourth straight year of the IRS suspending the penalty. What do you think it will take for this not to repeat in 2025?

Appleby: Here’s one of the distinctions that we need to make. The IRS is doing the best that they can. They don’t have the authority to waive the RMD, so they keep putting on that Band-Aid because they’re responsible for the excise tax? They can waive that. One of the recommendations I make is if you want them to waive RMDs, contact your congressperson and say, “Pass a law like you did under the Cares Act of 2020. During the pandemic, you waived RMDs.” That year was poof, no RMDs apply. That’s what we want for this because this 10-year rule is so confusing to everybody who is subject to it. Give them a break. Waive the RMDs so that we don’t have to have these convoluted explanations and so that they get an extension on the 10-year period. Call your congressperson. Tell him I sent you.

Hampton: Denise has provided detailed examples about inherited IRAs in her article. Please check out the show notes for a link. You don’t want to miss it. Thanks, Denise, for sharing your insights today.

Appleby: Thank you so much for having me. It was a pleasure.

Hampton: That wraps up this week’s episode. Subscribe to Morningstar’s YouTube channel to see new videos about investment ideas, market trends, and analyst insights. Thanks to senior video producer Jake VanKersen, lead technical producer Scott Halver, associate multimedia editor Jessica Bebel, and editor Margaret Giles. And thank you for watching Investing Insights. We really appreciate it. I’m Ivanna Hampton, lead multimedia editor at Morningstar. Take care.