What are Roth IRAs and how do they work?

They are part of the Individual Retirement Accounts (IRA) family. They have a special place in that family because they are completely tax free if you follow the basic rules. We’ll get to those rules in a bit.

Roth IRAs are like a special member of your family planning for retirement, much like a trusty dog. They can faithfully attend to their retirement “kitty” while keeping the tax wolf out the door. But, like any dog, they can bite if you don’t know how to treat them.

So here are some basic rules for setting up your Roth IRA to be a happy pet.

1. Make sure you are eligible.

qualified income: You qualify if you have earned U.S. taxable income from any of these sources: wages, salaries, tips, professional fees, bonuses, commissions, self-employment income, nontaxable combat pay, military differential pay, or taxable alimony. (Unfortunately, investment and rental income do not qualify.)

Also, your income must be below certain levels to qualify. For a 2011 contribution (made by April 16, 2012), your income must not exceed the following:

Single: Modified Adjusted Gross Income (MAGI) must be below $107,000, with a gradual reduction range of up to $122,000 for partial contributions.

Married Filing Jointly (MFJ): Joint income must be less than $169,000 MAGI, with a phase-out range of up to $179,000.

head of household or married filing separately who filed No Living with your spouse during the tax year: $107,000 MAGI with the same tapering range as the single person.

Married Filing Separately WHO did you live with your spouse during the tax year: you cannot contribute if you have more than $10,000 in earnings. Quantity reduced below that.

Your modified adjusted gross income is the adjusted gross income (AGI) from your tax return, adjusted for things like student loan interest deductions, rollover conversions, and foreign income. A lot of people don’t have much of it and can only use the AGI from their tax return.

2. How to keep your Roth IRA tax free

Keep it at least five years and up to age 59 or older. Remember, IRAs are for retirement, so it’s best to care for them until your senior years.

If you really need to use the money before you qualify for tax-free status, you can take it out under various hardship clauses. Some of these exceptions include taking advantage of the IRA for a first-time home purchase (up to $10,000 of IRA money you’ve had for more than 5 years), a disability, paying qualified educational expenses (tuition, books, school fees) or pay health insurance if you don’t have a job.

You can also withdraw IRA accounts under the Substantially Equal Periodic Payment (SEPP) rules. Get help if you want to do this, as it can be tricky. There’s a potential bite from the IRS if you’re wrong.

you can always take your contributions at any time without penalties or taxes, but not your winnings. For a complete list of ways to withdraw money from your Roth IRA without penalty, see IRS Publication 590 or the book Roth IRAs made simple.

What is the “bite” if you take the money out early? It’s a 10% penalty on your Roth IRA earnings, plus tax.

3. Know when, what and how much you can put into your Roth IRA.

If you qualify, you can put in the minor of: your yearly earned and taxable compensation OR the IRA limit for that year. You can never contribute more to an IRA than you have earned (or will earn) during that calendar year.

IRA Annual Contribution Limits they are the same for traditional and Roth IRAs. For 2011, it is $5,000 for people under age 50 and $6,000 for people age 50 and over. Each year, the government announces the IRA contribution limits for that year and they tend to gradually increase over time.

There is a 15-month window for contributions for any year. The window begins to open on January 1 of the year and closes on April 15 (or the tax filing date) of the following year. For example, for the 2011 calendar year, you can make a contribution beginning January 1, 2011, through April 16, 2012.

What types of investments can you make? Use almost any type, including mutual funds, stocks, bonds, certificates of deposit (CDs), exchange-traded funds (ETFs), and more.

A Roth IRA can be a wonderful way to save for your future. It can bring you truly tax-free earnings – a potential savings of thousands of dollars over many years.

In addition to that benefit, Roth IRAs have no required minimum distributions (RMDs). Most employer retirement plans and other IRAs require you to start withdrawing your money (and paying taxes on it) when you turn 70½. Roth IRAs are happy retired pets that will happily wait until you’re ready to use them.