The squashfs (mounted as /dev/root) is a compressed read-only filesystem, it is only ever as large as its (compressed) contents.
What you need to do is creating a disk image which is larger than the actual rootfs to allow LEDE to allocate the remaining free space as overlay partition.
On Linux one would create such an image with a command like dd if=lede-17.01.1-x86-64-combined-squashfs.img of=disk-image-padded.img bs=1M count=512 conv=sync
The alternative is using ext4 images as those are usually pre-created to have a larger than needed size.
If you build your own images, you can enable Target Images ---> Pad images to filesystem size (for JFFS2) in menuconfig to automatically perform the padding in the generated images. Enabling this option will cause the build system to pad the generated images to the size specified in Root filesystem partition size (in MB) within the same menu.