A mutual fund is in essence a way for investors to pool their money together for investment purposes. Although you can make deposits as well as withdrawals from a mutual fund, it is a mistake to look at it as a glorified bank account. That is because when you deposit money into a mutual fund account, you are actually purchasing stock in the mutual fund, not simply dropping your money into a bank account to accumulate some interest. By investing in a mutual fund, you own shares of stock in a company that in turn owns the investments. Income from this fund will produce dividends, not interest. This difference changes the way you report income when it comes to your taxes.
Keep in mind that when you withdraw money from a mutual fund that you are essentially selling mutual fund stock. This is important because when you take money out of a mutual fund, it is considered a sale of stock and therefore you are required to report a sale on your tax return. When you withdraw money from a bank account, the interest incurred is taxed before it goes into your account and you do not have to report anything on your tax return. That's a big difference from a mutual fund withdrawal.
If your mutual fund is part of a family of mutual funds that are under related management and you can move money from one account to another, do not be misled in believing that you are simply transferring money from one account to another within a single company. This is not the case. These transfers are actually taxable sales because when you transfer money from one account to another, you are selling one fund and buying one fund. This means that if the value of your shares in the first fund had increased while you were in possession of them, you will be required to report a capital gain on the sale on your tax return.
On a more upbeat note, some types of dividend on mutual funds are not taxable as ordinary income as dividend on regular stocks are. Special rules for mutual funds permit the tax treatment of certain types of income to flow through to the shareholders. If your mutual fund has a long-term capital gain, you get to report this as capital gain on your tax return. However, if your mutual fund has a short-term gain, the dividend is treated as ordinary income.
