What is an AFR and how do I pick one?

Note: Interest rates and the AFR are only applicable to the Amortization and Annuitization Methods of Calculating SEPP Distributions. If you are using the Minimum Distribution method, you do not need to select an AFR.

The term AFR stands for the Applicable Federal Rate: a set of interest rates the IRS publishes monthly. For a definition and uses of the published rates see here. There are over 70 rates in each publication, but only 1 is used in SEPP calculations, the 120% Mid-Term AFR (to make the reading easier, I will refer to the “120% Mid-Term AFR” as simply “AFR” for the rest of this post).

The easiest way to find and compare AFR rates to use in your SEPP is to reference the table in the 72tnet.com website, here, but since this website is about education, you should try to find the rates yourself, at least once.

To find the 120% Mid-Term AFR for the month you are considering starting your SEPP distributions, do a Google search for AFR and click on the Index of Applicable Federal Rates (AFR) Rulings at irs.gov, or click here. The list of publications will be sorted by the most recent month. Select the link for the month you want, then scroll down to page 2.

On page 2, find the Mid-Term table in the middle of the page, and go to row 3 for the 120% rates. Scan to the right to find the annual AFR for the month. See the highlighted rate in the example below:

The 120% Mid-Term Applicable Federal Rate is the AFR multiplied by 1.2 (.99 x 1.2 = 1.188).

For plans starting after January 2022, you generally have 3 choices of interest rates: 5%, last month’s AFR, or the previous month’s AFR. To quote IRS Notice 2022-6:

“The interest rate that may be used to apply the fixed amortization method or the fixed annuitization method is any interest rate that is not more than the greater of (i) 5% or (ii) 120% of the federal mid-term rate (determined in accordance with section 1274(d) for either of the two months immediately preceding the month in which the distribution begins).

Note: This website recommends selecting the highest AFR rate allowed. If the rate results in a SEPP distribution greater than you need, break your IRA account into 2 accounts. Use only one account for the SEPP and keep the other for emergencies later on.

There is one more interest rate that some SEPP Distribution Calculators ask for that requires explanation. Let’s use the calcxml calculator as our example.

The third box on the left asks for a hypothetical rate of return on investment. What they’re actually asking for is the average of how do you think your investments will grow over time. This rate is a wild guess, depending on how you choose to invest your SEPP assets. This rate is not needed to calculate your SEPP distribution amount, rather it is used to show how much you will have left in your account when the SEPP is complete.

This ending balance can give you a false sense of security because no one knows what your sequence of returns will be in the long run. If you enter a number in this box, use a very conservative (small) number such as 0% or 1%. Again, it does not impact your SEPP distribution calculation.

Historical note: Back in the late 1990’s folks were riding high on the stock market’s consistent double-digit returns and thought the boom would never end. The 12% expected return rate seemed reasonable back then, even to the IRS, who allowed AFRs to be any “reasonable” rate. Something very bad started to happen in 2001 after the stock market crashed – SEPP plans everywhere started to run out of money. Because of this nightmare, starting in 2002, IRS began to require SEPPs to use the published 120% Mid-Term AFR rather than allow folks to select their own AFR.

The 3rd box on the right of the calcxml SEPP calculator is a living example of when you could select your own AFR. Anyone who selected an AFR of 12% and didn’t experience average gains of 12%, risked depleting their SEPP account and running out of money. The 120% Mid-Term AFRs in late 2002 were about 3% and rose to over 6% in 2007. They’ve declined ever since the 2008 recession and nowadays we’re looking at AFR rates hovering around 1-2% (dropping under 1% to 0.7% in May 2020). See the history of the AFR rates back to 2002 on the 72tnet.com website here.