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Dave Ramsey’s College Savings Advice

Dave Ramsey’s College Savings Advice

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.

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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:

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:

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26 thoughts on “Dave Ramsey’s College Savings Advice”

  1. Oh, snap!

    Besides the reasons you listed against change investments frequently is that this encourages market-timing and performance-chasing. Ramsey’s practically asking people to buy good performers, then drop them if they don’t deliver. That’s a recipe for disaster – buy high, sell low.

  2. I personally can’t say whether Dave Ramsey gives good or bad investing advice, since I am just not educated enough on that subject. But he is THE best “get-out-of-debt” guy around IMO…and I am working very hard to prove that myself (3 more months to go…)

    What Dave Ramsey does say is when you are ready to invest, find an advisor who will teach you the right way to do it (“heart of a teacher”) so that you understand something before you put money into it. I know you only caught part of one show TV show (the radio show goes 3 hours a day) but he continually stressed to never invest in something you don’t understand.

  3. If you listened to Dave more, you would realize that he is not giving bad advice here.

    It seems one of your main reasons was that “average people could get into trouble with ESA’s, where 529 plans are fool proof if it’s with a good company.”

    Dave doesn’t dumb down advice to protect people from themselves. The ESA’s functionality is far superior to a 529 plan. Dave isn’t going to go with 529’s simply because they are easier. Instead, he recommends that you use a professional broker to assist you.

    And he wasn’t recommending high turnover investing. He never does. He was simply saying that it’s an option if for some reason you need to.

    The age limit doesn’t matter because Dave suggests you get the saving done before they go to college anyway.

    And the age usage limit doesn’t apply because Dave wants them to finish school in four years-and not sit around on the money.

    The contribution limit doesn’t matter because you only need so much for college and you can easily save more than the required amount in an ESA.

    The Tax contribution will save you very little, and Dave is in a state with no state income tax.

    As far as I’m concerned, his advice on ESA’s is perfectly sound–no mistakes made whatsoever.

    I think if you listened to Dave’s principles more, you would understand WHY he advocates certain things.

  4. I think he avoids 529s because they are more difficult to understand. Since each state is different, it’s impossible for him to explain it in a way that his audience can use.

    This isn’t the first time Dave Ramsey has given advice.

    Like My Dollar Plan, I like the Ohio plan as well.

  5. I think you glossed over the big reason ESAs can be better. Investment freedom.

    If you are locked into a 529 that gives you 5 choices A-E to invest in, none of which are that good, you are costing yourself a ton of money.

    If option C is the best at 7% year over year, but in an ESA you can get 12% with a fund you chose, we are talking a potential of $50,000 difference investing 2,000 for 18 years.

    I agree that people who are not savvy on picking good mutual funds yet, it would be overwhelming. That is why you would hire a good financial guy who would help train and teach to be able to make your own decisions.

    Just my two cents.

    PS – I would doubt that Dave would suggest that you should be buying and selling in an account. His recommendations are usually to pick great fund with 20-30 plus years of track records and let it ride.

  6. I couldn’t agree more!

    It is much easier for novice investors to pick a proper 529 plan than it is for them to pick well performing investments for an ESA.

    We use 529 plans for all our children, and have it set up so that all relatives can contribute to the funds, no limits and no requirements on income make them winners in my book.

    I would also like to mention that many sites/services like upromise.com and little grad.com will contribute to your 529 plans if you register your grocery store cards and the like. Just one more reason why I believe 529s are a better choice for regular parents who want to save for college without having to understand everything about investing.

    You have great insights!

    Take Care

    LJ

  7. I remain distinctly underwhelmed by Dave Ramsey’s investing suggestions. I wonder why he doesn’t get called out about it – maybe no one following Dave Ramsey actually gets to the investing stage, or (and probably more likely) they don’t realise what they don’t know.

    The ESA doesn’t sound like as good a wrapper as the 529 primarily because of the age limits. Not everyone will need their education money between the ages of 18 and 30. Some people do a stint in the armed forces, others get scholarships for undergraduate degrees, but return for graduate work some time later.

  8. Wow, a lot of good discussion here. Thank you for your comments! I am going to touch on some of your comments here:

    @THR:
    Investment freedom is the exact reason why Dave recommended ESA over 529. I am not saying that’s greater investment freedom is a bad thing, but for a vast majority of people that are inexperienced with investing, they are probably better off with more limited options. Sure you can get into a bad 529 plans, but there are some really good ones out there that offer good investment options at low cost — more suitable for inexperienced investors.

    Yes, I agree that people should learn to invest and consult professional to help them if needed, but ESA is not a good place to learn.

    @DFR:
    yes, that is part of it. I only caught a glimpse of his teaching and do not fully understand everything that he preaches. I didn’t know about Dave, until you told me about him. And I intend to watch his show when I can. I agree that he’s one of the best “get out of debt” guru.

    @Kevin:
    I always enjoy reading your perspective because we do not always agree 100% and you add a lot of depth to the conversation.

    * Professional assistance – finding a good one is an art in itself. May be I just have bad experience, but I prefer to do things on my own. Now let’s look at which is easier to do: (1) learn how to invest well versus (2) find good 529 plan and learn how to manage the few options with proven strategy of asset allocation, regular contribution, and rebalancing. I would say option #2 is better for a vast majority of people.

    * Contribution limit – “The contribution limit doesn’t matter because you only need so much for college and you can easily save more than the required amount in an ESA.”

    I beg the difference on this. Unless our system changed somehow, college will become increasingly unaffordable. Based on my calculation, we will have to spend about $250,000 for a good 4 years public college 17 years from now; unless he gets scholarship, financial aids, etc. At that rate, we need to save about $5,000 a year, not $2,000.

    * “Dave is in a state with no state income tax.” But his listeners are in all 50 states. The state income tax benefit shouldn’t be overlooked.

    * As far as following Dave more, I intend to do that.

    @Lazy Man:
    I think you meant: “This isn’t the first time Dave Ramsey has given [bad] advice.” We all do sometimes right?

  9. @plonkee: Quite a few people get to Baby Step 4 & 5 which are saving for retirement and childrens’ college funds. But at that point, many people do spread their wings and learn from people other than Dave Ramsey. There tend to be some lively debates about those stages over at MyTotalMoneyMakeover forums as to what qualifies as good investing advice.

    Dave Ramsey’s advice to NEVER invest in things you do not understand is still good advice.

  10. @Jason: Fox had nothing to do with Dave Ramsey other than signing him on after he had been on the radio here in the Nashville area for over 15 years! He is not one of “their experts” since he was successful before on his own before they ever contacted him.

  11. @Ana:
    That’s the kind of thing I was hoping to hear. I’d hate for people who have done so well at getting out of debt to be messing up a bright shiny future for no good reason.

  12. Over the course of the last 4 years, I’ve listened to Dave’s radio program hundreds of times. If you listen, you’ll find that Dave not only encourages SAVING for college, but BUDGETING for college, once a student begins school. Plus, he encourages living in inexpensive housing (dorms) and having a job. His goal is to promote a balance between retirement / education / and long-term savings.

    As for the advice Dave gives, his primary goal is to get people to “think” about their financial decisions. I for one owe a LOT of my progress to his plans. That being said, I’ve moved beyond “15%” in retirement and ONLY using an ESA – but, for folks who are brand-new to personal finance, I think Dave rocks!

    NCN

  13. Hey Pinyo, I think you’re being unnecessarily harsh on Ramsey (not that I’m a fan, everything I know about him I heard from someone else). Although you make a good point about needing to know something about investing before putting money into an ESA, the same really holds true for 529s too. And I think there are times when an ESA is a better choice than 529s, as in our case, when we’ll be paying for private school. We can withdraw money from an ESA as soon as the kids start kindergarten, so I’ve fully funded ESAs for them instead of opening 529s (though I’m always thinking about that).

  14. @Kevin – He probably is, but that doesn’t mean anything. Just because someone is a good practitioner, doesn’t mean he is a good teacher.

  15. @ Pinyo
    I see where your coming from but from my point of view, Dave Ramsey has helped tons of parents put their kids through college debt free.

    So his advice can’t be bad. It’s just different from what you recommend. Therefore, the title of your post should be “Dave Ramsey gives different advice about college savings than me”.

    Just my 2 cents.

  16. @NCN – Welcome to Moolanomy, and thank you for stopping by.

    “Dave not only encourages SAVING for college, but BUDGETING for college, once a student begins school. Plus, he encourages living in inexpensive housing (dorms) and having a job. His goal is to promote a balance between retirement / education / and long-term savings.”

    I think this is a great advice. I am not saying that he gives bad advice in general. I think he’s great and what he’s doing is admirable. I like the idea of teaching children to be financially responsible and to share educational expenses burden with their parents — I think they should do all of the above as Dave suggested.

    I just thought that this particular advice I heard was not that good.

    @CFO – Hi, there! I am not trying to be harsh on Dave. I just disagreed with this particular advice. 🙂

    Good point about using ESA for pre-college education expenses. That’s one nice thing about ESA — it’s more flexible in term of how you use the money.

    @Best – Welcome to Moolanomy.

    “Dave Ramsey gives different advice about college savings than me”

    It could be, but I still think presenting ESA as better because (10 it more investment options, (2) you can change to a different investment if you don’t like the one you currently have, and (3) because there are some bad 529 plans out there, still represents a “bad advice.”

    Regarding #3, there are a lot more bad investments to weed out than there are bad 529 plans.

  17. First, I am a Dave Ramsey fan, but I must admit he seems to be very naive when it comes to investing.

    Yeah, I know he has more money than me, but I often cringe when he gives investment advice.

    Anyway, it was a great post Moolanomy. First time here.

  18. I don’t understand how people could have a hard time picking the right investments. Look at the past returns for 10-20 yrs, and the expenses. I showed some mutual funds to my 9 yr old sister and even she knew which one to pick. (Duh it’s not the one with the 5% return)

  19. Full disclosure: I teach Dave Ramsey’s FPU at my church, so I am a fan. You must recognize two things: 1. Dave assumes that responsible investors, such as the ones with the foresight to plan for their children’s college, will do their research and only invest in quality, long-standing mutual funds with a good track record. 2. He is not suggesting you continually roll your investments around, focusing on short term results. He’s making a point that YOU have control over where the funds are invested, as opposed to allowing someone else dictate that to you. and 3. If you’ve ever listened (or watched) to Dave Ramsey, you’ll know that he has answered this question hundreds of times, so it’s not a “spontaneous” answer. The ESA offers a more flexible definition of “qualified education expenses,” thereby increasing the chances of using all of the funds in the account, and minimizing the amount remaining, which would be subject to penalties and taxes.

  20. 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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