You've probably heard that exchange-traded funds or ETFs have tax advantages over regular mutual funds. But to make the most of the advantages of ETFs, you need to understand why they're so tax-smart for your portfolio.

In the following video, Dan Caplinger, The Motley Fool's director of investment planning, explains the tax benefits of ETFs. He notes that traditional mutual funds often have high turnover, with active managers buying and selling shares and generating capital gains that they're required to pass on to shareholders. By contrast, SPDR S&P 500 (SPY 2.07%), Vanguard Total Stock (VTI 1.98%), and many other ETFs track popular indexes that don't have nearly the turnover that an active fund has. Dan reminds investors that you'll still pay income tax on dividend distributions, with popular dividend ETF iShares Select Dividend (DVY 0.01%) passing through dividend income along with most other ETFs, including the two mentioned above. Dan concludes that ETFs have special characteristics that make it easier for them to avoid unnecessary tax liability, which is valuable for investors seeking the highest after-tax returns they can find.

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