Tax savings are the most valuable part of the best-know Canadian tax shelter, the RRSP. But some investments can increase your capital gains tax if they’re sheltered in an RRSP.

Investors sometimes ask us whether they should hold certain investments inside or outside of this most-used Canadian tax shelter, the RRSP, to get the most tax benefits. Historically, there were certain investments that could increase your capital gains tax if you held them in your RRSP. That remains the case.

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

One key rule to follow in using this Canadian tax shelter 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 well into retirement. A capital loss in your RRSP deprives you of this benefit, which is the most valuable part of an RRSP.

Note that there is something to be said for holding interest-paying investments and foreign stocks in your RRSP, and Canadian stocks outside of it (although it’s okay to hold Canadian stocks in your RRSP if you want to). That’s because dividend income from Canadian stocks is eligible for the dividend tax credit, whereas 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, the primary benefit of that Canadian tax shelter being to defer taxes on investment gains. They think that bonds would be a better fit.

However, long-time readers know my general view on the stocks-versus-bonds dilemma.

You might say that what you get from bonds is the opposite of what you get from the stock market.

Inflation near-automatically reduces the purchasing power of bonds. Inflation can also hurt the returns you make in the stock market, of course. However, companies you invest in can take steps to cut the costs of inflation. They can pass on cost increases to their customers. They can introduce new processes and equipment to improve productivity and cut their costs.

In contrast, bonds and those who invest in them are generally at the mercy of inflation.

A stock can go down all the way to zero, of course. But that’s rare, and all but unknown when you follow our Successful Investor approach to investing. Stock prices fluctuate, sometimes wildly. But most shares of high-quality companies ultimately head upward.

If you hold on to a portfolio of high-quality stocks long enough, the gains you get out of it will dwarf your original cost.

In bonds, the opposite is true. Bonds have a clearly defined return, based on their stated interest rate.  The interest rate determines the maximum return. Of course, a bond can also go to zero, if only theoretically.

So, bonds and stocks can both go to zero. But bonds come with a fixed return. This puts a cap on the maximum return they can give you. In contrast, stocks have no limit on how high they can rise nor how much they can pay you in dividends.

That’s why we prefer to invest in stocks.

As a member of TSI Network, you may have already seen Capital Gains Canada: 7 Secrets for Managing Your Canadian Capital Gains Tax Liabilities. If you haven’t yet read this new free report, click here to download your copy today. I’d also encourage you to share the report with a friend as a way of making sure they’re making the most of all available Canadian tax shelters. The report is my “thank you” just for signing up for my free daily updates.

What else would you like to know about capital gains tax? Leave a comment below.

Note: This article initially published in 2010 and is regularly updated.