Faithfully saving money for your child's higher education might be all for naught if you're stashing cash in a savings account.
College savings accounts, known as 529 plans, offer families a way to save on a tax-favored basis: Money you save here accumulates on a tax-free basis.
Account holders may tap their cash tax-free if they are using it to cover qualified higher-education expenses, including tuition, fees, books and room and board.
If you tap the money for any other purpose, you'll be on the hook for ordinary income taxes and a 10 percent penalty, said Lazetta Rainey Braxton, a certified financial planner and founder of Financial Fountains.
Despite the benefits of 529 plans, many families still turn to alternatives.
More than 4 out of 10 parents saving for their children's education are pouring their money into general savings accounts — making it the most commonly used account for accumulating college savings, according to research from Sallie Mae, a provider and servicer of student loans.
Nearly a quarter of all college savings in the U.S. is held in savings accounts, Sallie Mae found.
Some 2,003 parents of children under age 18 participated in the survey.
Saving something is better than nothing, but there are better ways to grow that cash.
Even high-yield savings accounts are crediting only about 2 percent in interest, while the average savings account offers a yield of 0.09 percent, according to Bankrate.com.
New data from Morningstar show that families are missing out on an estimated $237 billion in state and capital gains tax benefits and market growth because they aren't using 529 plans.
"In the end, it's a lot of money being left on the table that they could otherwise have available for college," said Stephen Wendel, head of behavioral science at Morningstar and author of the paper.
Here's how to get the most out of your college savings.
A tax boon
On average, families that opt to stash money earmarked for higher education in savings accounts instead of 529 plans are missing out on an additional $4,044 per child over the course of 18 years, Morningstar found.
Of that $4,044, more than half of that money comes from investment returns.
Meanwhile, capital gains and income tax breaks provide additional benefits of $839 and $442 per child, respectively, according to Morningstar.
The study assumed that those who invest in these college savings plans are in a 529 plan with an average moderate glide path — that is, one that's allocated 80 percent toward stocks at the start of the child's life and will gradually decline to zero equities once the child is in college.
Benefits notwithstanding, data show that even middle-class families are using checking or savings accounts to sock away their college savings. See the chart below.
"As income increases, so do the amounts that people save for college, but as income goes over $100,000, people know how to invest it," said Wendel.
"But people are still saving significant amounts of money and putting it in savings accounts," he said.
In this case, poor marketing of the plans might be the culprit.
In a study of 810 individuals with children, Morningstar found that participants who received tables and graphs clearly stating the benefits of 529s indicated that they would save more.
"Simply presenting the plans clearly can make a difference," Wendel said.
What to look for
If you're shopping for a 529 plan, do your homework first. Here's where to start.
Search nationwide. More than 30 states offer tax incentives to residents who contribute to their college savings plans. There is no requirement that you choose your home state's plan, however. You may find a better deal elsewhere.
Know the fees. Expenses, including account fees and fund costs, erode your returns over time. Look up fee data as you shop for college savings plans. Savingforcollege.com allows you to compare plans based on expenses and state tax benefits.
Do it yourself or seek help. College savings plans can either be direct-sold — you purchase the plan on your own and choose your investments — or advisor-sold.
The difference in cost is sharp: The average fee for advisor-sold plans that invest in active funds can be as high as 1 percent, according to Leo Acheson, associate director of multiasset and alternative strategies at Morningstar.
Direct-sold plans with actively managed funds average about 80 basis points, while those with passive funds average around 25 basis points, he said.
Save early and often. A child who's a year old has a longer time horizon and more time to reap investment returns, compared with a teenager who's about to go to college. Contribute early and regularly.