With IRA Deadline Looming, Don’t Make These Mistakes

Ivanna Hampton: Here’s what’s ahead on this week’s Investing Insights. Disney CEO Bob Iger is reimagining the entertainment powerhouse’s future. Plus, Morningstar’s director of personal finance Christine Benz will share how to avoid making six IRA mistakes. And an examination of America’s racial wealth gap. A look at what’s driving it and how to potentially shrink it.

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 CEO Bob Iger Plans to Cut Billions

Disney DIS posted a decent start to the fiscal first quarter of 2023. And multi-billion-dollar cuts are coming in Bob Iger’s second stint as CEO. Iger says the company will shave more than $5 billion from the budget. That would include eliminating about 7,000 jobs along with big spending cuts on nonsports content. Disney is splitting into three divisions with ESPN as its own segment for the first time. Iger made clear the actions do not signal a potential spinout or sale of the sports network. The Disney Plus streaming service struggled, losing more than two-million customers globally. However, Disney said it expects strong subscriber growth in the second half of the fiscal year. The company reiterated that it still expects the streaming service to achieve profitability in fiscal 2024. The parks and consumer segment drove earnings, with domestic and international parks posting 27% growth. Morningstar still thinks Disney shares are worth $155 and currently look undervalued.

Uber’s Total Revenue Soars

Uber UBER delivered another impressive quarter with year-over-year growth in users, monthly trips, and monetizing its app. Top-line growth in the fourth quarter generated additional operating leverage and margin expansion. Total revenue was up nearly 50% year over year. Management showed impressive confidence about having a profitable quarter this year. That supports expectations that it’ll reach full-year profitability in 2024. Uber’s first-quarter outlook indicates continuing strong growth through 2023. Morningstar expects modestly lower gross bookings and revenue since an economic downturn will likely weaken demand. We’ve reduced our estimate of the stock’s worth by $5 to $68 a share but continue to view Uber as undervalued.

PayPal Faces Tough Environment

PayPal PYPL released a mixed bag of results for its fourth quarter as it begins the search for a new CEO. The digital payment platform struggled with revenue growth as it fights a tough industry environment likely through 20-23. However, cost-control actions are working, and Morningstar believes the outlook on margins has improved. E-commerce activity has slowed but payment volume and revenue both increased 9% year over year. Management is confident revenue growth will hold at this level. Their comments suggesting the company is holding its market share are encouraging. CEO Dan Schulman announced he plans to step down at the end of the year. The board should have time to find a replacement. However, Schulman says he could be flexible if necessary. Morningstar is sticking with its $135 estimate of PayPal stock’s worth and considers it undervalued.

AbbVie’s Long-Term Outlook

AbbVie ABBV reported fourth-quarter results that were in line with Morningstar’s expectations. But the company’s long-term outlook isn’t as healthy as competition moves in on its established products. Management is looking at big declines for the immunology drug Humira along with its cancer drug Imbruvica over the next two years. And the longer-term outlook calling for Imbruvica’s sales to stabilize seems too optimistic. Despite those challenges, AbbVie’s next generation of drugs should be able to replace lost sales from maturing products. The new immunology drugs Skyrizi and Rinvoq both saw big gains in the last quarter. They hold potential for future sales based on their success in studies versus branded competitors. Two recently launched migraine drugs also show promise in effectiveness and ease of use. Morningstar doesn’t expect to make any major changes to its $120 estimate of the stock’s worth and views the shares as slightly overvalued.

Racial Wealth Gap in America

February is Black History Month. Morningstar has analyzed the racial wealth gap in America. Researchers have found income and savings rates factor into the equation. Morningstar editor Keith Reid-Cleveland is one of the authors of “11 Charts Examining the Racial Wealth Gap.” Keith is joining me on Investing Insights to discuss it.

Hampton: Racial inequality has led to wage disparities among people of color. What has research shown when households are compared?

Keith Reid-Cleveland: Yes. Well first, let’s start by looking at the research that we actually did. We started off by looking back at widely publicly available data sources like the U.S. Census Bureau, the Brooklyn Institution, and the Survey of Consumer Finance. And we originally ran this article, the first version of it, back in January of 2022. And we’ve since updated it more as time goes on and more data becomes available. Now, as far as the current version that we just launched, current data shows us that Black and Hispanic households, respectively, hold 62% and 74% of an annual income in 2021 compared to the non-Hispanic white households. Now those are very similar numbers to what we saw 2020, and it just means the trend is kind of going forward as time goes on. And lastly, we also saw that generally from 2016 to 2021, across all racial lines, annual income has gone up.

Hampton: Keith, Morningstar researchers found that lower income is a direct cause of lower savings rates among Black and Hispanic households. Can you tell us about the savings rates?

Reid-Cleveland: Yeah, that’s correct. So, by “savings rates,” we’re talking about the amount of money that people are putting into a savings account, whether that be an actual savings account or some kind of a retirement account like a 401(k). And we looked at that across racial lines as well for our research. And in that we found that as of August 2021, Black households were only saving 0.6% of their income in savings accounts compared to 2% for Hispanic families and 6% for non-Hispanic white households. And when you add in the context of the income disparities that we talked about in our last question, you start to see how this can become an ongoing trend over time that builds and gains momentum.

Hampton: Now, what about building a nest egg?

Reid-Cleveland: Yes, building a nest egg is absolutely important. Some of the first advice you’ll get from any financial professional you talk to, whether that be for investing or just general savings in that regard. But it’s not as simple as that. The notion of someone having to do away with daily expenses like saving for coffee or something like that, using that money to pay down student loans isn’t really conducive or sustainable long term because, at the end of the day, if you’re not making as much, you’re not able to save as much. You can’t save, spend, or invest what you don’t have.

Hampton: Now, a lot of people consider homeownership as a path to financial security. What are some thoughts on building wealth this way?

Reid-Cleveland: That is a very wide-ranging conversation and actually, to help answer that, I reached out to a combination of Morningstar researchers and collaborators and I posed that exact same question about how much of a vehicle can homeownership be for upward economic mobility. And we found that Morningstar’s Brian Bernard said that, historically, homeownership definitely is one of the most stable ways to build wealth over time, but the problem is due to structural barriers. It’s not as available to people of color, and they’re not able to get into that game in the first place. And moving on from there, we saw that Morningstar contributor Brian Thompson agreed that homeownership has a lot of upside, absolutely, but it’s not perfect, in his words, because Black homeownership specifically is on par with where it was in the 1970s, but it’s definitely down from where it was in its peak in the 1990s. And at this point, in comparison, non-Hispanic white homeownership actually peaked in 2020. So those are two very different narratives that we’re seeing take place.

Hampton: So, economists Darrick Hamilton and William Darity proposed creating baby bonds to help close the racial wealth gap. What are baby bonds, and how do they work?

Reid-Cleveland: So, baby bonds are a concept that have been around for quite a while, actually. And essentially it’s the idea that the government would find families of lower income and contribute funds to children born to those families when birth on an annual basis up until they turn 18. Once they turn 18, now those now-adults can essentially use that money for a big life expense such as college education or for a first-time home purchase as well or a down payment. And essentially the idea behind this is that they’ll be able to use that money to get ahead. And this money would be contributed across racial lines, not only to people of color but to anyone that falls in these certain thresholds. And then from there our own Morningstar researchers, Aron Szapiro and Lia Mitchell, did some research and tested baby bonds on how they could play out in a variety of scenarios. And in the best-case scenario, they found that it could potentially help shrink the racial wealth gap by as much as half.

Hampton: Wow. Thank you, Keith, for this discussion today about the racial wealth gap in America and baby bonds.

Reid-Cleveland: Thank you. I’m happy to be here.

Hampton: You can still contribute to your 2022 IRA if you haven’t fully funded it yet. But the window of time is shrinking as April 18 gets closer. Here’s Morningstar’s director of content Susan Dziubinski and Morningstar’s director of personal finance Christine Benz with some advice.

6 IRA Mistakes to Avoid in 2023

Susan Dziubinski: Hi, I’m Susan Dziubinski with Morningstar. It’s IRA season, which is the period before Tax Day when people rush out to fund their IRAs. Joining me to discuss six IRA mistakes to avoid this year is Christine Benz. Christine is Morningstar’s director of personal finance and retirement planning.

Nice to see you, Christine.

Christine Benz: Good to see you too, Susan. Let’s delve into some of these mistakes. You say the first key mistake that people often make is rushing to contribute at the last minute to an IRA. Why is that an issue, and how can people avoid it?

Benz: Right. When investment providers look at when people make their contributions, they often do take it down to the wire. So, they rush in their IRA contribution, say, for 2022 right before the tax-filing deadline, which in 2023 is April 18. The reason you don’t want to do that is foregone compounding. It’s not a big deal if you do it one year. But if you do it year after year, that’s 12 months, maybe 15 months of foregone compounding. So, I think that ideally, you would get those contributions in as soon as you’re able to make them. You can make your 2023 contribution now as of Jan. 1. You could start funding that 2023 IRA. I like the idea of people doing that. Or maybe looking at a dollar-cost averaging plan where you’re putting regular sums in each month, because in a lot of households that total IRA contribution can be kind of a heavy lift. So, why not space it out to make it more manageable for yourself?

Dziubinski: Now the second mistake that a lot of us make is somewhat related, and it’s maybe you will fund the IRA but then you delay going in actually getting that money invested. Let’s talk about that and what people are sacrificing as a result of not getting those dollars invested more quickly than they often do.

Benz: Right. This is another insight from investment providers. Vanguard did some great research a few years ago, where they looked at what they called the procrastination penalty. They looked at this two-factor issue where people are late getting these contributions in, and sometimes they put the money in, but they don’t put the money in anything. It just sort of sits there in the cash account. I think a great way to work around that is, assuming these are funds that you are setting aside for your own retirement, why not use a target-date fund here as well? I think they’re arguably underutilized in the IRA context. Of course, people use them very much in 401(k) plans. But I think they’re equally effective, equally hands-off and easy to use in the years leading up to retirement as a target-date fund would be in a 401(k).

Dziubinski: Speaking of getting those IRA funds invested, one risk that you think some investors may face this year in particular is being too conservative with how they invest those IRA assets based on what we saw in the market last year. Let’s talk a little bit about that.

Benz: Right. I think there are two factors at play here. I’m hearing a lot of enthusiasm for very conservative investments, cash investments in part because stocks were bad last year, bonds were bad last year, but also yields are starting to look pretty compelling. You can earn a 4% FDIC-insured return on a savings account today or on some sort of CD or very safe account. The risk, though, I think if you’re a younger investor especially is that you are locking in a very low yield. You will not be participating in the equity market’s potential for gains. So, my thought is that for younger investors, conservative investments probably aren’t a great fit. They probably want to be more long-term-oriented. And we can all just fall into this trap of recency bias, where the very recent past affects what we do. If you’re a younger investor or even sort of an intermediate-term investor with 10 years to retirement, you probably don’t need extremely safe investments within your IRA.

Dziubinski: Another mistake sometimes investors will make is that they can’t make an IRA contribution because they earn too much money. So, how can investors get around income limits when it comes to IRAs?

Benz: Right. So, people will see their income limits if they want to make deductible traditional IRA contributions. There are higher income limits that apply to Roth contributions. If you look at those Roth contribution limits and say, “Well, I make more than that.” Don’t assume you’re shut out. You can take advantage of what’s called the backdoor Roth IRA maneuver. And the basic idea is that you fund a traditional nondeductible IRA. There aren’t any income limits on that type of IRA. You can fund it as long as you have earned income of any kind. You can earn a lot of earned income and still make that traditional nondeductible contribution. So, you fund that type of account. And then, shortly thereafter ideally, you convert it to a Roth account, and there aren’t any income limits on those conversions, either. So, it’s a great way to get funds into an IRA, even if you are a higher earner who can’t make that direct front-door IRA contribution.

Dziubinski: With the backdoor IRA contribution, though, if investors do have a lot of IRA assets in general, they have to be a little careful with that. Let’s talk about that.

Benz: Right. It’s such a good point, Susan. There’s what is called the pro rata rule that applies to all of your traditional IRAs. And if you’re doing conversions or you’re taking distributions from your IRAs, from your traditional IRAs, the IRS looks at the composition of those IRAs. So, if you’re just making that little nondeductible contribution and doing the conversion, if you don’t have any other IRA assets, that shouldn’t cost you much in taxes. If, on the other hand, you have a lot of assets in a traditional IRA that consist of deductible contributions, so funds that you’ve never paid taxes on, that could cause the conversion of your small new IRA to be at least somewhat taxable. So, do your homework on what the tax bill might be. It’s not a reason to necessarily avoid doing that backdoor maneuver but just understand that you may owe a little bit more in taxes than would be the case if you just had that single, nondeductible traditional IRA that you were converting and doing the backdoor maneuver with.

Dziubinski: Got it. The last mistake you think that investors sometimes make is that they reflectively choose the Roth IRA as the option and don’t really consider the traditional IRA. Why is that?

Benz: Right. Well, there’s a lot to like about Roth. You are able to take tax-free withdrawals in retirement. Who doesn’t like that? And then, there aren’t any required minimum distributions on Roth IRAs, either. So, two big advantages of having Roth IRAs. But the reason that some people should look at making a traditional deductible IRA contribution is if they’re in a relatively high tax bracket at the time of contribution relative to where they might be when they begin pulling the funds out in retirement. So, a great example would be kind of a late-career saver, earnings are fairly high, but that person hasn’t saved a lot for retirement. In that case, he or she might be better taking the tax break today at the higher tax level and then paying taxes on the funds in retirement upon withdrawal. So, run the numbers on that. It’s not automatic that Roth IRA is the right answer for everyone. And then, I would also say, we’ve been watching with Secure 2.0, which was a piece of legislation that passed at the end of last year, we’ve been watching the required minimum distribution limits, the age limits, on traditional IRAs go up and up and up, and they’re going to go up further in 2033, all the way to age 75. That, in a way, is taking away what had been one of the big knocks on traditional IRAs that you’re subject to these RMDs, and I think making it a little less of an issue for many households.

Dziubinski: Well, Christine, thank you for walking us through these mistakes today and hopefully, we won’t make them anymore because we’ve been listening to what you’ve just told us. Thank you for your time.

Benz: Thank so much, Susan.

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

Read About Topics From This Episode

Disney Reports Decent Earnings With Iger Already Reapplying His Stamp

Uber Reports Impressive Q4; Strong 2023 Growth Expected

PayPal Remains a Unique Player in Payments

AbbVie Posts Solid Q4, but Competitive Pressures to Limit Long-Term Growth

11 Charts Examining the Racial Wealth Gap