The interest earned on policy dividends is:

• A. Considered a return of premium and not taxable.
• B. Tax-free under all circumstances.
• C. Taxable only if the policy is surrendered.
• D. Taxable as ordinary income.

Answer: (D)

Verified step by step guidance

1. Understand the concept of policy dividends: Policy dividends are typically considered a return of premium paid by the policyholder, but they may generate interest if left with the insurance company.
2. Clarify the tax treatment of interest earned on policy dividends: While the dividends themselves may not be taxable, any interest earned on these dividends is considered taxable income.
3. Recognize the classification of taxable income: Interest earned on policy dividends is treated as ordinary income for tax purposes, meaning it is subject to standard income tax rates.
4. Distinguish between the taxability of dividends and interest: It is important to separate the tax treatment of the dividends (return of premium) from the interest earned (taxable as ordinary income).
5. Conclude that the correct answer is based on the tax treatment of the interest earned, which is taxable as ordinary income, regardless of whether the policy is surrendered or not.