Mutual funds pool the investments from a number of investors to buy a variety of securities, such as stocks and bonds. Each investor receives a pro rata share of each security and is entitled to a pro rata share of all gains generated within the fund. Investors also receive a pro rata share of any tax obligation generated within the fund. The way withdrawals are taxed depends on the type of gain or loss the fund generated.
A mutual fund is a type of investment security. Mutual funds are not demand deposit accounts such as a checking account or savings account. You must sell, or redeem, shares of your mutual fund in order to access the funds in your account. This is true even for money market mutual funds, which may resemble traditional checking accounts by giving you access to your funds through drafts or debit cards. While accessing the funds in your mutual fund by one of these means may appear similar to making a withdrawal, you are actually selling shares of your mutual fund.
You will typically incur a capital gain or capital loss when you sell shares of your mutual fund, in the same manner that you would incur a capital gain or loss when you sell shares of stock. If you sell your mutual fund shares for more than you paid for them you will have a capital gain, which may be long term or short term -- depending on how long you have held the shares. If you sell your mutual fund shares for less than you paid for them you will have a capital loss, with which you may be able to offset some of your capital gains. Shares of money market mutual funds are typically maintained at $1 per share, so there is usually, but not always, no capital gain or loss on the sale of these shares.
The securities held by your mutual fund may pay a dividend or interest to the fund. The fund's management may buy and sell securities within the fund, which may generate long- or short-term capital gains. The tax obligation for these transactions passes through to the individual investor. Distributions that are automatically reinvested into additional shares of the fund are taxed in the same manner as distributions that are received in cash. Portions of the distribution may be taxable as long-term capital gains, ordinary income or interest income. Some portions may be exempt from federal or state income tax, depending on the source from which the income was derived.
The mutual fund company should provide you with a Form 1099-DIV for any taxable dividend distributions you receive. It should provide you with a Form 1099-INT if you received any tax-exempt interest distribution. You should use these forms to report your mutual fund withdrawal income when you file your federal income tax return.