Student Loan Debt Cancellation: How a Sinking Fund Can Help

Borrowers may look to sinking funds as a way to help plan for potential student loan debt cancellation. These specialized funds are money set aside for specific goals, and the payment of student loan debt could be one of them. In the event that a borrower has their student loans canceled, a sinking fund can be a fallback option for paying any resulting tax bills.

Why It Matters

According to Federal Student Aid, an office of the U.S Department of Education, some federal student loan borrowers could be eligible to have their student loans discharged, forgiven or canceled. If this happens, a borrower may not be required to pay back a canceled loan balance. The Public Service Loan Forgiveness program (PSLF) is one of the most common pathways to student loan cancellation.

During the COVID-19 pandemic, the U.S Department of Education allowed for a temporary change in the rules and qualifications for the PSLF program. Federal Student Aid reports that, "As of mid-July 2023, approximately 662,000 borrowers have qualified for forgiveness under the limited PSLF waiver." Statistics from the Education Data Initiative show that "18.4% of eligible student borrowers apply for loan forgiveness" and "14.4% of PSLF applications have yet to be processed."

US President Joe Biden arrives to speak during an event to announce that his Administration has approved $1.2 billion in student debt cancellation for almost 153,000 borrowers at the Julian Dixon Library in Culver City,... ANDREW CABALLERO-REYNOLDS/Getty Images

What To Know

The Corporate Finance Institute defines a sinking fund as "a type of fund that is created and set up purposely for repaying debt." It's similar to a standard savings account, except the money put here is designated for a specific purpose. A sinking fund could be more flexible than the more common accounts associated with saving for education expenses, like an Education Savings Account (ESA) or a 529 plan.

Since the money in a sinking fund doesn't have account-related restrictions, savers can use this money how they choose. Sinking funds can cover a range of savings goals. You can have a sinking fund to cover the cost of a house, a pet's needs or a vacation.

For those who don't qualify for student loan debt cancellation, a sinking fund for college expenses can help borrowers repay their debts. Anyone who does qualify for student loan forgiveness could use a sinking fund to pay your taxes. Taxation on canceled student loan debt can differ depending on if you're dealing with taxes on the federal vs. the state level.

Alex Beene, financial literacy instructor for the University of Tennessee at Martin, told Newsweek: "When it comes to student debt forgiveness, at the federal level, the American Rescue Plan waives taxes on forgiven student debt. However, that plan only goes through 2025, and legislators will have to vote to extend it for that benefit to remain." The American Rescue Plan is an initiative implemented by the Biden Administration to provide direct relief to Americans in light of the COVID-19 pandemic.

"State taxes get a tad more complicated. Some states, like the federal government, waive taxes on forgiven debt, while others do tax those cancelled loans. You need to check with a tax service in your area to make sure you're following the proper procedure for your state's policy." Beene continued.

What People Are Saying

Jared Walczak, vice president of Tax Foundation, told Axios: "Whether Congress or the president through administrative action forgives student loans... if it's between 2021 and 2025, it will not be taxable income for federal purposes."

Alex Beene, financial literacy instructor for the University of Tennessee at Martin, told Newsweek: "You want to make sure you're making your monthly student loan payment, and a sinking fund to pay off more in the future is a solid idea. At the same point, if cancellation is looking like more and more of something that will never come to pass for your loans, it may be better to skip the fund and just pay any additional amount you can to your loan each month and save some on future interest."

What Happens Next

Eligible borrowers can still apply for federal student loan forgiveness through the PSLF program. If you do get your student loan debt canceled, make sure to check with your state to know if you'll be required to pay taxes on forgiven loan balances.

If you're considering using a sinking fund as a way to help pay off debt or pay for any tax charges on forgiven debt, there are tools to help you build one successfully.

"When it comes to sinking funds, there's one word that is above all others: automate. However you're setting that money aside, you need to automate the process as much as you can," Beene told Newsweek.