Dave Ramsey’s College Savings Advice

By Pinyo, on January 16, 2008

On Monday night, I stumbled upon the Dave Ramsey Prime Time on Fox Business Network Show, and stopped channel surfing to watch it. I heard about Dave Ramsey through my friends — many of whom greatly admire him (e.g., Ana, Randall, Lynnae, Gibble, and Mrs. Micah). Personally, I like how he helps thousands of people get out of debt and live financially healthier lives. So, what I am about to tell you was a shocker to me.

Toward the end of the show, a viewer asked about the best way to save for college. I don’t recall the exact words used, but Dave’s advice went something like this:

For college savings, I recommend Education Savings Account (ESA). This is similar to your retirement IRA. You can contribute up to $2,000 per year, you can invest it anyway you want, and it grows tax free. If you want to contribute more than $2,000, then I recommend that you look into 529 plans. However, there are a lot of bad 529 plans out there and they are not very flexible. With an ESA, you can choose whatever funds you want to invest in. If you don’t like it, you can roll it over to another fund as many times as you like.

The above is not an exact quote, but I think it accurately captures the gist of Dave Ramsey’s college savings advice. When I listened to this, I thought, “No way! that’s a terrible advice.” Granted, I understood the limited time, and how difficult it is to provide a well thought out answer when you have to do it spontaneously. So nothing against Dave, but I’d like to dig into this college savings advice, and tell you why I thought it was bad.

Note: When I talk about 529, I refer to direct plans because that’s type I prefer.

Why I Thought Dave Ramsey’s Advice Was The Best?

More Investment Options

Assuming the viewer was an inexperienced investor, advising him to choose ESA over a 529 College Savings Plan to take advantage of broader range of investment options is actually more harmful. I believe that inexperience investors are better off choosing a good 529 plan — i.e., ones managed by TIAA-CREF or Vanguard — and stick to broad index funds that passively track the market.

Yes, Dave is right about the presence of bad 529 plans. There are some out there, but it’s still easier to find a good 529 Plan than learning how to properly invest in the stock market via an ESA. There are plenty of helpful resources like the comparison chart from SavingForCollege.com and Kiplinger Top Plans, that will make choosing a good 529 College Savings Plan easier.

I am afraid that someone who’s not knowledgeable about investing could run into some of these common pitfalls:

• Choosing bad investments — be it, stocks, mutual funds, or ETFs
• Paying too much commissions for trades
• Selecting mutual funds, or ETFs, with high expense ratio
• Selecting mutual funds that have front-end load and/or redemption fee
• Not being able to diversify enough with the small initial fund

By choosing a good 529 plan that offers no-load, low cost funds — i.e., New York’s 529 College Savings Program — a lot of these potential pitfalls could be avoided.

Change Your Investment As Many Times As You Like

You’re kidding right? That’s the kind of advice that will make an investor lose his shirt. High turnover trading is plain old bad money advice. There are many costs, hidden and not so hidden, associated with changing mutual funds, or worse actively trading stocks and ETFs. Some example of these costs include:

• Trade commissions
• Front-load fees
• Redemption fees
• Bid-ask spread

Asset Allocation, Regular Contribution, and Rebalancing

Personally, I believe the best strategy for inexperienced investor is to invest in low-cost passive mutual funds using asset allocation, regular contribution, and rebalancing to enhance performance. In general, these three things are easier to do with a 529 plan:

• Asset Allocation – Most 529 plans offer several funds in different asset classes. You can set it up so new contributions are automatically distributed among different funds. This would be a completely manual process with an ESA.
• Regular Contribution – As you may know, I like to build wealth little by little and automatically. In my 529 plan, I have the plan automatically transfers money from my bank account each month. Depending on your financial institution, automatic contribution to ESA may not be possible.
• Rebalancing – Rebalancing capability is a standard feature in many 529 plans. With a few mouse clicks, I could redistribute money among different funds to restore the original asset allocation percentages. With an ESA, this would be a manual (tedious and expensive) process of buying and selling individual funds and stocks to get the asset allocation mix right.

Five More Reasons Why 529 is Better Than ESA

Broader investment options was the main reason why Dave liked ESA better than 529. But there are so many advantages to using 529 that Dave didn’t mention. Here are five of them:

1. Contribution Age Limit — Age of the beneficiary doesn’t matter when it comes to 529 Plans; however, you cannot contribute to ESA once the account beneficiary reaches age 18. This is one of the neat features that allow you to start a 529 plan before your child is even born.
2. Deadline for Using the Funds — With ESA, the beneficiary have to use the money by age 30. Money in a 529 plan could be used at anytime during the beneficiary’s lifetime.
3. Maximum Contribution — There is a $2,000 per beneficiary per year limit for ESA. The maximum contribution limit for 529 savings plans vary by state but they are generally much higher than ESA.
4. Phase Out Limit – 529 plans have no income limit, ESA does. According to Money-zine.com, “…the income limit for making a maximum contribution…for married couples filing joint tax returns…phase out at $220,000 in 2007 and 2008. For those not filing a joint return, the contribution limit is $110,000.”
5. Tax Advantage – Similar to Roth IRA, ESA contributions are not tax deductible. However, some states — e.g., New York — allow 529 contributions to be deducted from state income for tax purposes.

So there you have it. I think Dave is a great guy and I love his 7 Baby Steps, but even he is not infallible — we all make mistakes right?

More on 529 Plans versus Education Savings Account:

• Comparing A 529 Plan And An Education Savings Account (ESA) at My Two Dollars
• Choosing a 529 Plan at Lazy Man and Money
• Saving Money For Your Child’s Future: A Different View at Financial Baby Steps (interesting perspective)
• Coverdell Education Savings Accounts at Money-zine.com

Leave Your Comment (26 Comments)

1. Michigan Money says:

   June 7, 2010 at 2:25 pm

   One thing that everyone has missed on this blog is that Dave Ramsey’s advice about ESA and 529s are all at risk to the market … Dave’s book and at least one other poster states that you should invest in these types of vehicles and earn 12% ror … Tell me who has received 12% over the last 10 years? The market history reflects that you would have been lucky to receive a total return of 12% for the entire 10 years. 10K deposited in a 529 or ESA in 2000 would be worth less today no matter if you were indexed to S&P, Nasdaq or Dow. Dave’s advice for investing worked well from 1982 to 1998 but the wheels have come off over the last 10 years. I guess that is not long enough term for Dave

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