Under Cut, copy, and paste, select the down arrows to change the different paste scenarios. Finally, choose between Keep Source Formatting, Merge Formatting, and Keep Text Only.

It's worth noting that Merge Formatting is now set as the default paste option on Word, though you can change it back by navigating File > Options > Advanced > Cut, copy, and paste in the settings ...

After creating the key, copy it and return to PowerToys. Find Advanced Paste and then click the Enable button next to Enable Paste with AI. Paste in your API key and click Save.