I don't understand *why* or *how* index funds are relatively tax efficient, though. I realize it has something to do with interest income versus capital gains. I'm just not sure I understand fully. Are dividends the interest income? Is it the fact that with most index funds, most of the returns come in the form of capital gains rather than dividends?
Basically, index funds are considered tax efficient because they typically don't trade very often. The broader the index, the less likely there will be trading. For example, every year the composition of the S&P 500 changes by a few companies. When that happens, the fund has to sell and buy shares of the companies that respectively fall out or get included into the index. When that happens, taxable gains/losses (in the form of capital gains) are generated. By way of comparison, total market index funds are even more tax efficient. Since those funds ostensibly contain the entire market (not really, but close enough), there are even fewer changes there every year (relative to the overall size of the index) in comparison to a fund indexed to the S&P 500.
Dividends are not interest. It does help some people to think of them that way, but they're really not the same. Certainly qualified dividends are handled differently from interest income by the IRS, although that might change soon. Also, note that interest rates and company dividends are influenced by very different things.
And remember that capital gains within a fund are only generated if stocks are sold. So if the value of your fund goes way up but the fund itself hasn't sold any funds, it's entirely possible that your annual statement would show very little in the way of capital gains. In fact, your dividend amount could exceed the capital gains amount, although the bulk of portfolio growth might come from the rising values of the stocks held in the fund.