We may be compensated by advertising and affiliate programs. See full disclosure below

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 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 the type I prefer.

Why Did I Think Dave Ramsey’s Advice Wasn’t 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 a 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 a 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 an 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.

— 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.

— 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 were 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:

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. Deadline for Using the Funds — With ESA, the beneficiary has to use the money by age 30. Money in a 529 plan could be used at any time during the beneficiary’s lifetime. 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. 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.” 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?