Saving cash in jars Not the most efficient way to save for college. (Image: Shutterstock)

American families are leaving more than an estimated $237 billion on the table by not investing their college savings in 529 plans.

Morningstar’s new research paper “New Lessons About 529s” aims to provide new research on investor goals and behavior.

The paper uses survey data to explore

how and why American families are not taking advantage of 529 college-savings plans.

The paper points out that the single largest source of money that American families use to pay for college, after scholarships and grants, is loans. According to research by student-loan provider Sallie Mae, savings cover only 13.5% of the bill.

Education savings accounts — like 529 college savings plans — could help parents have more money available for college, and therefore borrow less. However, based on Morningstar’s analysis of Sallie Mae data, only 16% of families saving for college use the 529.

The paper looked at a nationally representative sample of American households, the Survey of Consumer Finances, to examine what would happen if every household saving for college used 529s instead of other types of accounts.

The paper looked at a sample of American households with children younger than 18, drawn from the U.S. government’s 2016 Survey of Consumer Finances. Morningstar then used data from Sallie Mae’s 2018 “ How America Saves for College” report to estimate how much each household in the survey has saved thus far for their children’s education and where they are saving that money (529s, other investment accounts or checking/savings accounts).

Then, for each household, Morningstar considered an alternative scenario.

“What would happen if, at the birth of each child, the family had directed all education savings for their children into a 529 instead of other vehicles? How would the potential benefits of 529s translate into additional money for each family?” the paper asked.

The paper essentially examined what money is left on the table because families use other vehicles that lack the tax advantages of 529 plans.

Throughout the analysis, Morningstar left each family’s contribution rate unchanged; this analysis looked solely at the effect of using a 529 instead of other vehicles. Similarly, for families already using a 529, no change occurred with those funds (and thus they received no additional tax benefit).

From this analysis, Morningstar found that if American households used 529s exclusively for college savings, the benefits would be considerable: an estimated $237 billion by the time their children attended college. For the average family, this comes to $4,044 per child.

Digging deeper, the paper found that the $237 billion in additional wealth comes from three sources: $26 billion from unused state tax benefits, $50 billion from unused capital gains tax benefits, and $161 billion from the (post-tax) benefit of investing college savings.

“The largest single benefit of 529 plans comes from moving existing savings into an investment account — and earning higher returns in exchange for additional risk,” according to the paper. “To be clear, that is not a benefit that occurs solely with 529s; it’s one that all investment accounts share.”

However, many families use savings and checking accounts instead of investment accounts to hold their college savings.

“529s simply encourage families to invest those funds,” the paper stated.

Of the $4,044 total per child mentioned above, Morningstar found that $2,763 comes from investing otherwise uninvested funds. The added benefits from the unique aspects of 529s, capital gains and income tax incentives, provide a smaller bump of $839 and $442 per child, respectively.

“Collectively, this is a significant amount money. And, for a given family, it represents an opportunity to borrow thousands of dollars less when it’s time for college,” the paper stated.

The paper also looks at it another way. According to Morningstar, the average family could save 25% less and still have the same amount available when their child is ready for college by saving all of those funds in a 529 plan with a standard investment strategy to reduce risk exposure over time.

— Check out Are New USA Plans a Boon to Savers? Bloink & Byrnes Go Thumb to Thumb on ThinkAdvisor.