Why ETFs are tax efficient

Many ETFs are considered tax-efficient because of how the creation/redemption mechanism works. When large investors redeem shares, ETFs can often deliver securities "in kind" instead of selling them for cash. That can reduce realized capital gains inside the fund and lower capital gains distributions to shareholders.

But "tax-efficient" isn't the same as "tax-free." You may still owe taxes on dividends or interest distributions, and you'll owe capital gains tax when you sell your ETF shares at a profit in a taxable account.

Tax efficiency also varies by asset class and structure. Broad U.S. equity index ETFs tend to be among the most tax-efficient, while bond ETFs and some commodity/derivative products can generate more taxable income.