(MONEY Magazine) – For parents struggling to save enough money for their children's college bills, tax breaks have been few and frustrating. An Education IRA? So far, all you can put away is a paltry $500 a year--barely enough for pizza money--and that's only if you don't bump up against strict income limits. A custodial account? The tax savings are minimal, and you give up control of the assets to your kid. State-run prepaid tuition plans? They lock you into subpar returns. Little wonder that most parents end up saving in taxable accounts--thereby sacrificing a big piece of their profits to Uncle Sam--or raiding their retirement accounts.

Enter the 529. These state college savings plans, named after the section of the tax code that governs them, are the more attractive younger siblings of prepaid tuition programs. Anyone, regardless of income, can open an account and invest a hefty amount in stock and bond funds (more than $150,000 in many states). Most plans let you in with as little as $25 a month. The money can be used at any school in the country, and you keep control until the child goes to college. Best of all, the money grows tax-free until it's withdrawn, when earnings are taxed at the student's rate, usually 15%. (There are proposals in Congress to make 529s completely tax-free, as well as to expand the Education IRA.) To top it off, many states offer additional tax breaks of their own.

Given the generous tax advantages--plus the opportunity to shelter enough cash to actually make a dent in those six-figure tuition bills--529s are on their way to becoming the collegiate version of the 401(k). Today some 35 states operate 529 savings plans; 29 of them are available to residents of any state. Six more states will launch 529s by year-end, and another two states have authorized programs this year. More good news: States are increasingly turning over the operation of their 529s to established money-management firms. TIAA-CREF, with 12 state plans, dominates the field, but others are grabbing a piece of the action--among them Fidelity (three states), Merrill Lynch (three) and Salomon Smith Barney (two)--using the states as launching pads to market plans nationwide.

Investors have already stashed $2.5 billion in 529 plans, an amount that could grow to $10 billion by 2002, according to Joseph Hurley, who runs savingforcollege.com, a website that tracks college savings plans. Declares Hurley: "People are starting to realize that 529s are the best college savings plans to come along."

We agree, with a few reservations. Unlike 401(k)s, these new programs--most are no more than a year or two old--may not be right for everyone. One major limitation is the lack of flexibility: Once you select an investment option, you cannot change it--unless you follow a cumbersome rollover procedure. If you need to tap the account for any reason other than education, you will pay a 10% penalty. Another flaw: A 529 account can end up hurting your chances of obtaining financial aid (as we'll explain in a few minutes).

So how do you know if a 529 is for you? That's what the first section of this special report will help you determine. If your answer is yes, the following section will help you figure out which of the 38 states with plans (or plans on the verge of opening) best suit your situation--taking into account taxes, investment options, management fees and so on. Finally, we will outline how best to manage a 529 plan once you've signed up.

We also answer the 10 most frequently asked questions about 529s in the box on page 102. And, in the tables that begin on the facing page, we present a state-by-state assessment of the most important 529 features and identify the plans that stand out. We're confident that, by the time you finish this article, you'll have a precise understanding of how 529s work--and how best to make them work.

SECTION 1 ENTRANCE EXAM

Shortcomings and all, 529 plans are a hard-to-beat way to boost your college savings--provided you meet one of these four criteria:

You're in an above-average federal tax bracket, with time to save. The critical advantage that 529 plans offer is tax-deferred compounding. And as investors schooled in the basics of 401(k)s and IRAs know, the higher your tax bracket and the longer your time horizon, the more tax-sheltered compounding can add up.

In theory, you could build a tax-efficient college savings portfolio without a 529: Simply buy and hold top-quality individual stocks or mutual funds that keep taxable distributions to a minimum (like those on page 70). That way, you won't pay taxes until you need your money. The problem, however, is that as your child nears college age, employing a pure buy-and-hold strategy isn't necessarily a good idea. The last thing you want is to have your college nest egg stung by a bear market (like the one we've felt recently). So even when your child is in middle school, you should start shifting college savings out of stocks and into lower-risk bonds and cash. All that asset shifting triggers tax bills--something that doesn't happen with 529 plans that adjust allocations for you. "The real-world advantage of investing tax-sheltered in a 529 beats the theoretical advantage of investing for low capital-gains taxes," notes Raleigh, N.C. financial adviser Brian Orol.

When you compare a 529 plan with a balanced fund that shifts between stocks and bonds, the tax advantages are obvious. According to TIAA-CREF, an investor in the 31% tax bracket (adjusted gross income of $105,950 or more for married couples filing jointly; $90,800 for single heads of households) who saves in a 529 plan for 18 years would come away with 20.5% more than someone who puts the same amount in the typical taxable balanced fund. Investors in lower tax brackets can benefit as well, but, as you'll see below, those parents need to focus on more than taxes.

You are unlikely to qualify for need-based financial aid. As adviser Raymond Loewe of College Money, a planning firm in Marlton, N.J., puts it, "The tax savings you get in a 529 plan blow up when it comes time to qualify for aid." Here's why. Under financial aid formulas, 529s are counted as the parents' asset until you withdraw the money. That's when the problem sets in. Gains from a 529 count as the student's income, up to 50% of which is considered available to pay tuition. The income from a taxable fund held in a parent's name is assessed at about the same rate (47%). The key difference is that the fund has been distributing gains all along, which reduces your taxable gain--and the number plugged into the aid formula--when the fund is sold to pay for college. Complicating matters even more is the fact that private schools can set their own rules. Plus, aid formulas will eventually be updated.

All this means is that anyone who might qualify for aid--parents currently earning less than $100,000--may be better off saving outside a 529. If you're in the 31% bracket, however, you probably won't qualify for substantial need-based aid. (Possible exceptions are families with more than one child in expensive colleges at the same time.) Even if you do qualify, you'll probably receive most aid in the form of loans, not grants. To avoid borrowing later, it makes sense to save in a 529.

What if your financial situation changes after you've begun funding a 529? If you later find yourself in a position where you are likely to be eligible for financial aid, try and wait to take withdrawals from your child's 529 until the last year of college, when it won't be counted against future financial aid.

You live in New York, Michigan or another high-tax state with significant 529 tax breaks. If your state offers a generous tax deduction on 529 contributions, take a serious look at the plan even if you are in a lower tax bracket. (State tax exemptions on withdrawn earnings are helpful but worth less than an up-front deduction.) In New York, for example, residents earning more than $40,000 are taxed at a rate of 6.85%; if you live in New York City, add on 3.78%. The state's 529 plan, run by TIAA-CREF, offers a state-tax deduction on contributions of up to $10,000 per household a year (no matter the number of kids), which can save New York City residents as much as $2,038 a year. That makes the plan a clear choice for most New Yorkers, says Anthony Ogorek, a financial adviser in Buffalo. To calculate the value of your deduction elsewhere, go to www.money.com.

You're a grandparent looking to reduce your estate. You can deposit up to $50,000 ($100,000 for a married couple) into a 529 plan without incurring the federal gift tax, making 529s an ideal way to move a big sum out of your estate quickly. A $50,000 contribution is counted against your $10,000 annual gift exclusion over five years, so you won't be able to make another tax-free gift to that beneficiary for six years.

SECTION 2 HEAD OF THE CLASS

Okay, you're sold on 529s. But which one is best for you? As you can see from our state-by-state tables, no two programs are alike--they differ dramatically in many ways, from investment choices to costs to tax breaks.

Your first step should be to look at your own state's plan (if it has one). In five states, you may qualify for a matching grant or scholarship (see "State Aid" on page 103). More important, 16 states give residents a tax deduction on 529 contributions, and 25 exempt the earnings on withdrawals (six exempt earnings on out-of-state plans as well). Thirteen states offer both breaks. If your state taxes are high and your local plan offers generous tax benefits, you can stop reading here: You're best off staying at home.

But what if you live in a state with low or no taxes--or with limited tax breaks? Then it's time to shop around. In the tables, we've indicated our five favorite plans--Iowa, Michigan, Missouri, New York and Utah. But your family's specific needs may point you in another direction. We'd suggest that you do your own comparison shopping using the following three rules.

Shop for a manager, not a performer. Given the short track record of 529 plans, you can't glean much from the funds' performance history. So stick with plans run by investment companies with successful records managing retail mutual funds and pension plans, such as Vanguard, Fidelity and TIAA-CREF, to name a few. At TIAA-CREF, for example, the same team that manages retail funds also guides the 529 portfolios.

Stick with low-cost plans. Expense ratios vary considerably, from 0.31% in Utah to 2.24% in Oregon. Some states' plans are sold by brokers, which layers on additional costs. If you buy the Arizona, Ohio, Rhode Island or Wisconsin plans through a broker, for instance, you could pay 3.25% to 5% up front in commissions. With all four plans, you can avoid a sales charge by buying direct, although in Ohio and Rhode Island you must be a resident to do so. The Maine plan run by Merrill Lynch comes in two versions: one with four funds that's sold directly by phone--and a broker-sold series with more funds but higher fees.

You could also pay other fees. About half a dozen states charge to open an account (usually $10--but $85 in Virginia). Fourteen plans tack on $25 or so in annual fees, although you can often get the up-front or annual fee waived if you sign up for an automatic investment program--or if you buy directly by phone or the Web.

Look for the right investment choices, not the most. The typical 529 menu is still fairly limited. In most plans, the key offering is an age-based portfolio, which gradually shifts the asset allocation as your child ages. For children under three, for example, some 80% of the portfolio may be stashed in stocks. As your child grows, the equity portion shrinks, so that by the time he or she is 18, the assets are held mainly in bonds or cash, ensuring that you can meet that first tuition bill.

Increasingly, states are adding conventional stock and bond funds to the original age-based portfolios. Maine, Nebraska and Arizona now offer 10 or more funds, including foreign and technology portfolios. But because you can't switch your money around freely the way you can in a 401(k), a vast number of choices isn't much of an advantage--and potentially riskier.

For most investors, the best choice is an age-based portfolio. In the past, these funds were criticized by financial advisers, as well as by MONEY, as being too heavily oriented toward fixed-income assets, even during the child's youngest years. But in light of the recent market bloodbath, a conservative strategy suddenly looks more sensible. "People forget that they usually have fewer years to save for college than for retirement--most often 10 years or less, since they tend to start late," notes TIAA-CREF vice president Timothy Lane. "If you lose a lot in the early years, it's very hard to make it up."

To help you find a mix that suits your tolerance for risk, we included allocations for three- and 10-year-olds in our state-by-state tables. Five states also now offer two or more types of age-based portfolio (see "Pick Your Risk" at right), with allocations designed to suit either risk-oriented or cautious investors. You can also create your own stock and bond mix by opening more than one account in the child's name--one for each asset class--and controlling your own allocation by the amounts you invest in each. Another strategy: If you don't like the asset mix choice designed for your child's age, find out if you can use a portfolio for a different age. Some states, such as Colorado and Virginia, let you pick your own starting point.

SECTION 3 YOUR ASSIGNMENTS

Once you're ensconced in a 529 plan, review its growth twice a year to make sure you're saving enough. When it comes time to make withdrawals, you cannot pay the taxes with money from the 529, since that's not a higher education expense. So be sure to tuck away enough cash to finance the tax bill.

If you aren't relying on an age-based portfolio to regularly shift allocations, it's important to make those changes yourself so that you don't get caught short in a market downturn. To do so, you may need to roll over your existing account (see the Q&A box on the facing page for details on how to do this).

One more point to keep in mind, notes Judy Miller, a college financial adviser in Alameda, Calif.: State contracts with money managers to operate 529 plans are typically set for just five to eight years. So your state may switch your manager down the line. But chances are, by that point, 529s really will be the equivalent of 401(k)s, and you can simply pick up the phone and move your money if you aren't happy with the change.