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Tip: Social Security questions are taxing

Why are so many Social Security recipients confused about whether they must pay federal income taxes on their benefits? Perhaps it's because the answer is sometimes "yes," sometimes "no" and, always, "it depends."

"The taxable portion is anywhere from zero all the way to 85 percent," says Christine Fahlund, a senior financial planner with T. Rowe Price. Where you are on the tax scale depends on your income. The confusing part is you have to account for revenue that isn't typically subject to taxes.

But first, the good news. A portion of your benefits is never subject to federal taxes. "At least 15 percent of your benefits will always be tax-free, regardless of how much money you make," Fahlund says. And for those who believe the Empire State is king when it comes to taxing its subjects, New York does not tax Social Security benefits.

The key to whether your benefits are taxable is computing what the Social Security Administration calls "combined income." Unlike adjusted gross income used as the tax basis on every 1040 tax form, combined income also includes tax-exempt interest and tax-exempt dividends. A quick rule of thumb to compute combined income is to take your adjusted gross income, add in all tax-exempt earnings and then add in one-half of your Social Security benefits. If the number is above $25,000 ($32,000 for married taxpayers), a portion of your benefits is subject to federal taxes. The actual numbers are computed on the IRS Form 1040 "Social Security Benefits Worksheet."

To illustrate, let's use the example of Sarah, a 67-year-old single filer. She had three sources of income in 2010: $1,500 a month in Social Security benefits, $25,000 in tax-exempt interest and a $10,000 withdrawal from a traditional IRA (which is considered regular income). Even though her $25,000 in tax-exempt income isn't included in her adjusted gross income, it must be included in her combined income along with half her benefits ($9,000). This gives her a combined income of $44,000. Bottom line: About 70 percent, or $13,000, of Sarah's Social Security benefits are taxable (see chart).

Fahlund says the one source of funds not included in combined income is Roth IRA withdrawals.

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