Any distribution of money you receive from a mutual fund is usually a capital gain distribution, an exempt interest dividend, nontaxable return of capital, or an ordinary dividend.
1. An ordinary dividend is paid out to you from its earnings and profits. It is reported as dividend income on your tax return.
2. Capital gain distributions are long term net realized capital gains from the fund. The money is based on projections of how well the fund would do. You report them as long term capital gain on your tax return regardless of the amount of time you have had ownership of the funds. A small part of this is undistributed capital gains. These are like a ghost income, you never have it in your hands but you have to pay taxes on it anyway. You can claim these as a tax credit on your return because you are considered to have paid them.
3. Exempt interest dividend is paid from tax exempt interest earned by the mutual fund. Hence, you do not have to pay taxes on this dividend, but you must report it nevertheless.
4. When you receive money out of your mutual fund that is not part of the earnings or profits but is part of your investment, it is called a nontaxable return of capital. The money is tax free because that was part of your principal in the fund. This reduces your basis in the mutual fund. Even when the basis becomes zero, you must report it on your tax return as capital gain.
