What is the tax implication for interest earned on certain financial instruments?

The correct answer is that only interest is taxed. This is based on the tax treatment of income generated from various financial instruments, such as savings accounts, bonds, and other interest-bearing accounts. In general, the principal amount—the original sum of money invested or loaned—does not incur tax. Instead, it's the interest earned from that principal that is subject to taxation as income.

Tax laws often treat the principal as a capital asset rather than income, so when individuals or entities earn interest, that income is reported and taxed accordingly. Understanding this distinction is crucial for anyone managing finances, as it affects both reporting obligations and overall tax liability.

The other options describe scenarios that do not align with standard tax treatment. For example, stating that both principal and interest are tax-free misrepresents tax implications in most jurisdictions. Taxing only the principal at a reduced rate would also contradict the way financial returns are evaluated for tax purposes. These nuances highlight the importance of knowing how interest income is treated under tax law, reinforcing the correct answer.