Mutual fund investors need to be wary of the tax consequences of owning mutual fund shares. Unlike individual stock and bond shares, taxation of mutual funds is quite complex. The categories of taxable mutual fund income include ordinary dividends, capital gains dividends, and capital gains on the redemption of fund shares.

Ordinary dividends are dividends or interest passed on to you from the holdings of a fund. Funds pay these dividends monthly, quarterly, or semiannually. Dividends are taxed at the lower capital gains rates. If you reinvest your dividends, they will still be taxed, unless they are part of certain retirement plans.

Although municipal bond funds earn dividends that are federally tax-free, their dividends may be taxable in your state if the bonds were issued by another state.

A capital gain is the profit you earn when you redeem fund shares that have risen in value. It is important to remember that you only have capital gains after you have sold your shares. While they are still in your hands, they are only a profit on paper. Therefore, you are taxed on them only when they are sold.

Capital gains are either short-term or long-term. Short-term capital gains are gains on shares that have been held twelve months or less. Long-term capital gains require that the shares be held longer than twelve months. At present, the tax rates on short-term gains are the same as the shareholder's income tax bracket: 10 percent to 35 percent. The rates on long-term gains range from 0 percent for taxpayers in the 10 percent and 15 percent tax brackets to 15 percent for those in the 25 percent tax bracket and above.

When a mutual fund sells shares of its holdings and earns a profit on them, it passes its net profit on to its shareholders as a capital gains dividend. You will be taxed at the short-term or the long-term rate depending on how long the fund held the shares.

When you shift money from one fund to another, even between funds in the same family, the Internal Revenue Service views it as a sale of your shares and a new purchase. You will be taxed on any capital gains made from the transfer. The exception to this is when transfers are made within a qualified retirement plan or individual retirement account.

Knowing the tax implications of mutual funds will help you to avoid being caught unprepared when the government comes to take its share of your earnings.