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New Study Finds You Need More Than Just Money to Save for College

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Saving for college is a state of mind. That’s the (simplified) takeaway from new research on 529 college savings plans.

Researchers at the University of Chicago found what they described as a "striking paradox at the heart of America’s college affordability crisis": Financial constraints do limit what parents can stash away in a 529 account, but behavioral barriers may be just as critical as economic ones.

In fact, in one part of the study, the researchers found that 61% of parents who could save enough to pay for half of their child’s future college costs didn’t think their savings would be "meaningful."

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The findings show that “there’s more that needs to be done in explaining the value-add of these plans… and helping parents make better financial decisions for their kids,” says economist Guglielmo Briscese, who coauthored the study.

College savings plans, also called 529 plans, are investment accounts that offer tax-free growth and withdrawals if you use the money for qualified expenses. In some states, you can also get an income tax break to sweeten the deal further.

While these plans were originally designed to help pay for higher education, the list of qualified expenses has expanded in the past decade to include K-12 private school tuition and student loan debt.

Americans hold more than $500 billion in roughly 17 million 529 accounts, according to the College Savings Plan Network. Yet surveys of parents consistently show that the accounts are underutilized, with many parents reporting they don’t know much — or anything — about how 529 plans work.

Lack of financial literacy is a major barrier

For the study, the researchers surveyed a representative sample of parents in Illinois, narrowing in on the roughly 70% of respondents who said they were not saving in a 529 account.

When asked about their concerns regarding the accounts, “I couldn’t save enough money to meaningfully reduce the cost of higher education” was either the first or second most commonly cited response across income levels.

To dig in further, the researchers asked the parents how much they could afford to put into a savings account each month if they were using a 529 plan. They then compared how much the parents would be able to save over the years with the expected cost of college at the time their child would turn 18.

That’s where they discovered how frequently parents underestimated their own savings. In addition to the 6 in 10 parents who thought their savings would not cover a meaningful amount — even though they could potentially save up to half of college costs — 66% of parents who could save enough to cover between one-third and one-half of college expenses also saw their potential savings as meaningless.

The researchers chalk up the discrepancy to gaps in financial literacy. Parents may not be fully grasping fundamentals such as the power of compound interest — “You have to save a lot less if you start earlier,” Briscese says. And they may lack more nuanced information about college financing.

“We find a strong and significant correlation between low levels of financial literacy and a high likelihood of underestimating the future cost of college, underestimating how meaningful their monthly contributions can be and also overestimating the financial aid probability amount,” he remarks.

Other misconceptions about how 529 plans work were also critical factors. A majority of parents cited the burden of paperwork associated with opening an account, even though it takes just 10 minutes, Briscese says.

Another persistent misunderstanding is how money in 529 plans is treated in financial aid formulas. Parents frequently think saving will hurt their chances at getting a scholarship, and the researchers found that was a common concern among this population of parents, too. The reality? Money in 529 accounts does reduce your child’s financial aid eligibility — but only by 5.64%. That means for every $10,000 saved in a 529 plan, you could lose up to $564 in financial aid.

All of these barriers to opening an account held fairly steady across income groups, which suggests that a common criticism of 529 plans — that they primarily benefit the wealthy — isn’t quite true, Briscese says.

And when there were differences by income groups, the barriers for wealthier parents were still significant. About two-thirds of parents earning under $150,000 cited not having enough money as a reason for not saving in a 529 plan, but even among parents earning above that amount, 46% cited similar challenges with financial constraints.

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Why poor uptake and use of 529 plans matter

In addition to surveying parents, the researchers also looked at data from more than 900,000 529 accounts in Illinois, where they found behaviors linked to financial literacy resulted in some "suboptimal saving strategies."

For example, although the state of Illinois allows individuals to deduct up to $10,000 in 529 contributions from state income taxes, the more common annual contribution was $1,200. This suggests parents may be depositing $100 a month for simplicity's sake, rather than figuring out either how much they can actually afford or how much they need to save based on projected college costs.

In another example, parents who set up automatic deposits — typically a smart move — rarely changed their deposits over time, meaning they didn't update the frequency or amount. This resulted in lower cumulative savings in the long run.

"Just because you have parents who overcome the administrative hurdle of opening an account, you should not assume that they are set for life and that they are making the best decisions for themselves and for their kids," Briscese says, adding that the researchers' findings show the need for financial education both in opening an account and in helping parents make the most of it.

This is also the first study that actually links 529 data to educational outcomes for hundreds of thousands of students. Even after controlling for income, that data shows that higher savings in a 529 is correlated with “improved educational outcomes including four-year college enrollment, attendance at selective institutions and pursuit of postgraduate degrees.”

With so much focus today on college affordability and the burden of student debt, it’s critical to try to help parents understand how useful a 529 plan can be, Briscese says.

“Every dollar you save in a 529 plan today will be more than a dollar less that your kid will have to take out in student loans in the future,” he says.

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