How to get the most capital gains tax benefits from your RRSP

Investors sometimes ask us whether they should hold certain investments inside or outside an RRSP to get the most tax benefits.

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Holding speculative stocks in your RRSP can increase your capital gains tax

One key rule is that it’s best to hold speculative investments outside your RRSP. Losses are inevitable with speculative investments. If you hold them outside your RRSP, losses provide you with tax-deductible capital losses that can reduce your payable capital gains tax. Inside your RRSP, losses simply reduce the capital you have available to take advantage of an RRSP’s tax-deferral power.

It’s especially crucial to observe this rule when you’re young. Your RRSP’s tax-deferral power continues until you take all the money out, and by then you may be in your 90s. A capital loss in your RRSP deprives you of this benefit, which is the most valuable part of an RRSP.

There is something to be said for holding interest-paying investments and foreign stocks in your RRSP, and Canadian stocks outside of it. That’s because dividend income from Canadian stocks is eligible for the dividend tax credit, where interest income and foreign dividends get taxed as ordinary income.

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High-quality stocks beat bonds as RRSP investments

Some financial planners say that stocks are too speculative to hold in an RRSP, because of the risk. That view made sense a decade or two ago, when interest rates were two or more times higher than they are today.

Now the situation has reversed. With interest rates now at historic lows, bonds can’t go a lot higher than they are. In fact, it seems more likely that rates will hold steady or rise slightly in the short term, and move higher still in the long run. That means bond investors would only earn interest income on their bonds; instead of capital gains, their bond holdings could produce capital losses.

In our view, that combination of high bond prices and the risk of higher inflation makes even the highest-quality bond portfolio more speculative than a well-designed stock portfolio. That is, a stock portfolio that’s built according to our three-part investment strategy: invest mainly in well-established companies, downplay stocks that are in the broker/public-relations limelight and spread your money across the five main economic sectors (Manufacturing & Industry; Resources; Consumer; Finance; and Utilities).

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