A mutual fund is in essence a way for investors to pool their money together for investment purposes. Although your client 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 your client deposits money into a mutual fund account, they are actually purchasing stock in the mutual fund, not simply dropping their money into a bank account to accumulate some interest. By investing in a mutual fund, your client owns 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 your client reports income when it comes to their taxes.
Keep in mind that when your client withdraws money from a mutual fund that they are essentially selling mutual fund stock. This is important because when they take money out of a mutual fund, it is considered a sale of stock and therefore they are required to report a sale on their tax return. When your client withdraws money from a bank account, the interest incurred is taxed before it goes into their account and they do not have to report anything on their tax return. That's a big difference from a mutual fund withdrawal.
If your client's mutual fund is part of a family of mutual funds that are under related management and they can move money from one account to another, do not be misled in believing that they 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 they transfer money from one account to another, they are selling one fund and buying one fund. This means that if the value of your client's shares in the first fund had increased while they were in possession of them, they will be required to report a capital gain on the sale on their tax return.
On a more upbeat note, some types of dividend on mutual funds are not taxable as ordinary income as dividends 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 client's mutual fund has a long-term capital gain, they get to report this as capital gain on their tax return. However, if their mutual fund has a short-term gain, the dividend is treated as ordinary income.
