If you're covered by a retirement plan at work but make too much money to get a tax deduction for contributing to it, you can often still contribute on a nondeductible basis. However, depending on your investment objectives, you might find the nondeductible IRA too limiting.
Nondeductible IRA Advantages
Even when you can't deduct your traditional IRA contribution, you still get the advantage of tax-sheltered growth. This means that no matter how often the investment creates otherwise taxable income, you don't have to pay any of those taxes until you take distributions. For example, if you were trading stocks in your nondeductible IRA, you won't have to pay taxes on the gains every time you sold a stock — which helps your gains compound at a faster rate.
Nondeductible IRA Disadvantages
The IRS restricts the maximum nondeductible contribution to your traditional IRA each year, so there's only so much you can put in. As of 2012, the maximum yearly amount is $5,000 ($6,000 if you're 50 and older). In addition, if you take distributions before you turn 59 1/2, the taxable portion of the distribution is hit with a 10-percent additional tax penalty unless an exception applies (such as certain medical expenses). Finally, some limitations on your investment options apply to money in an IRA. For example, you can't invest in a business you own or in collectibles like gems, jewelry or artwork.
Taxable Account Advantages
Using a taxable account allows you to invest in any legal investment, including your own business, a house you're going to live in, or collectibles. You can also cash out your investments any time you want without worrying about penalties. Finally, your investment might be taxed at the lower capital-gains rate if you hold your investments for more than one year, whereas IRA distributions are always taxed as ordinary income.
Taxable Account Disadvantages
Using a taxable account for your investments does have its downsides. Most importantly, you don't get to shelter your investment from taxes while it's in the taxable account. This means that each time you sell a stock, you'll have to pay taxes on the profits, which can slow the rate at which your account value grows.
Mark Kennan is a writer based in the Kansas City area, specializing in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."