(MONEY Magazine) – At long last, parents struggling to save for their children's college education have received a much needed break: a tax-free way to save for college. The new tax law allows you to make withdrawals from state college savings plans, also known as 529s, completely free of federal taxes if the money is used to pay college expenses. (Previously, 529 savings plans were only tax deferred.) That change gives parents a fighting chance to make a dent in those scary, six-figure tuition bills. Little wonder that the 529, named for the section of the tax code that governs it, is fast becoming the leading college savings plan. Last year, assets in these accounts surged from $1.5 billion to $10 billion. And Financial Research Corp., a Boston financial services consulting firm, predicts that those assets will balloon to $100 billion by 2006, a tenfold increase.

Before you join the stampede to 529s, though, you need to understand what you're getting into--these plans still have major drawbacks, as we will explain. Perhaps the biggest problem of all is that 529 plans are absurdly complicated, which can make shopping for a plan somewhat daunting. Each of the dozens of plans available has its own set of rules, investment options and tax treatment. No single plan is right for everyone.

But let's start with the good stuff. Unlike older prepaid state tuition plans (also called 529s), these savings plans allow you to invest in one or more stock or bond funds, somewhat like a 401(k). Anyone, regardless of income level, can open an account, and you may contribute enough to pay for an Ivy League education plus law school. You can also tuck away tiny amounts, as little as $25 a month. The money can be used at any college in the country, and you maintain control of the account until the money is withdrawn to pay the bills. Most states offer additional tax breaks of their own. (One caveat: Three states still tax the earnings on money withdrawn from their 529 plans, and 14 tax withdrawals on out-of-state plans. But the taxes are generally paid at the student's low state tax rate--typically just 1% or 2%.)

When it comes to selecting a 529, there's no shortage of choices. Almost all states permit nonresidents to put money into their plans--and many are actively marketing their plans nationally. At last count, 43 states were offering 529 savings plans (eight sponsor more than one program), and six more were set to launch this year. Most have hired well-known investment firms to manage their 529 assets. TIAA-CREF leads the pack with contracts for 14 state plans; other money managers operating multiple plans: Fidelity (three), Merrill Lynch (three) and Strong (three). A growing number of states sponsor plans with investment options from a variety of fund families. And 22 states are now marketing their 529 plans through advisers as well as directly.

"There's an arms race among the state plans to add investment options in order to attract investors," says Lisa Baird, a consultant at Cerulli Associates in Boston. "And because broker-sold plans are building assets so quickly, many states are adding those plans on top of their no-load offerings." Even no-load firm TIAA-CREF is considering adding a load share class to its 529 offerings to be sold through advisers.

Now for those drawbacks. For starters, despite the tempting tax breaks, 529 savings plans are not the best choice for every family. As we will explain in detail, these plans remain best suited to high-tax-bracket investors who are certain that their family will not qualify for financial aid, since money in 529s can reduce any award. You also need to be aware that a 529 can lose money. The stock-heavy portfolios in these plans have suffered badly in the recent bear market along with most other equity funds, posting double-digit losses.

In addition, your investment flexibility can be limited in a 529 because most still offer only a handful of funds. An Internal Revenue Service rule change now allows you to switch your investment choice once a year; until this year, you had to follow a cumbersome rollover procedure. But you still lack the investment control available in 401(k) plans, where you can usually make daily trades. You also need to be aware that the tax-free savings break is set to expire by the end of 2010. Unless Congress renews the law, 529s will revert to their old tax-deferred treatment starting in 2011, which means that earnings will be federally taxed at the student's rate, typically 15%, at withdrawal. Most financial advisers expect that the tax break will be extended, but there's no way to predict with certainty what Washington will do.

Given the complexity of 529s and the confusing number of options, more investors are turning to advisers to guide them through the maze. If you take that route, be sure your adviser is well versed in all plans, not just the one he or she is being paid to sell you. And remember that you'll be paying a sales charge or higher annual expenses or possibly both. (For more on adviser-sold plans, see page 94.) These programs are also popping up in the workplace as an employee benefit, but the 529 that your company offers isn't necessarily the best option for you (see "529s at Work" on page 96).

All of this may make you feel that you need a college education in 529s before you choose the right one for your family. That's why we've put together the following crash course. In Part 1, we offer guidelines for deciding whether a 529 plan is really right for you. If your answer is yes, move on to Part 2, which will help you select the best plan for your financial situation. We conclude with advice on how to best manage your 529 investment.

For a quick review of the mechanics of these plans, check out our answers to the 10 most frequently asked questions about 529s on page 93. Finally, in the comprehensive tables that begin on the facing page, we present a state-by-state rundown of key 529 features and highlight the plans that we think make the grade. Now let's begin.

LESSON 1: COLLEGE SAVINGS PLANS 101

Sure, the tax breaks are fabulous, and you can sock away plenty. But to really come out ahead in a 529 plan, you should meet at least one of the following criteria.

You're in a lofty tax bracket with a long time horizon. Tax-sheltered compounding really works its magic if you are in a high tax bracket--typically 30% or above--and stay invested for many years, as the chart on page 84 shows. According to calculations by TIAA-CREF, a parent who invests $2,000 annually for six years in an age-based 529 portfolio will likely come away with $16,100, assuming history's average returns on stocks, bonds and cash. That's 17% more than a high-bracket investor would have earned in an identical taxable fund. If you continue investing $2,000 a year for 18 years, you will end up with $85,100, or 41% more.

Granted, you can minimize taxes on college savings without locking up your money in a 529 simply by buying and holding individual stocks or investing in tax-efficient mutual funds. That way, you won't incur taxes until you take your money out, and those taxes may be quite low because the long-term capital-gains rate will fall to just 18% in 2006. (Those in the 15% bracket pay only 8% on assets held more than five years.) But keep in mind, you will need to shift from stocks to more stable fixed-income investments as your children reach high school. In a taxable portfolio, interest on those investments is taxed at your regular income rate. But in a 529, income from bonds and other fixed-income investments can accumulate tax-free, making a 529 an even more tax-advantaged choice for a mixed-allocation portfolio than it is for all-equity accounts. Plus, in a 529 plan you can move your money within the account or switch to a different plan, all without incurring a tax bill.

You are not relying on financial aid. A 529 account may count against you more heavily than money held in a taxable account when it comes time to qualify for financial aid. "The decision to choose a 529 plan is basically a trade-off between saving tax dollars now and receiving aid dollars in the future," says financial adviser Raymond Loewe of College Money in Marlton, N.J. Unfortunately, figuring out whether you will be eligible for aid, and how much you may receive, is a guessing game for middle-income families, particularly parents with young children who are decades away from applying. But if your kids are headed for college in a few years, you can--and should--get an estimate of your aid eligibility by completing the worksheets available in college handbooks or by using online aid calculators such as those at Finaid.com or Collegeboard.com.

Here's how the rules work right now. Under current federal financial aid formulas used by most public colleges, 529s are considered the parent's asset until the money is withdrawn. Federal aid formulas assess only 5.6% of parents' assets when considering how much they should contribute to tuition, compared with 35% of student assets. Any 529 money held in accounts controlled by grandparents or other relatives is not counted at all. Once the money is withdrawn, however, the untaxed earnings from the account are assessed as the student's income, which reduces any financial aid award by 50[cents] on the dollar. As a result, some families who stash substantial amounts in 529s may end up qualifying for less financial aid than if they had saved the same amount in a taxable account.

Be aware too that the financial aid rules governing 529s may change significantly. With the renewal next year of the Reauthorization of the Higher Education Act, which governs federal financial aid policy, the rules for 529 plans will likely be spelled out for the 2004-05 academic year. "The money in 529s will be counted, the question is how much will be counted," says financial aid expert Kalman Chany, author of Paying for College Without Going Broke.

Meanwhile, private colleges are free to consider 529 assets however they wish when it comes to awarding their own aid. Many schools are already asking about 529 accounts owned by parents, grandparents and other relatives. "With endowments shrinking and less money available for aid, it will be hard for private colleges to ignore 529 money," says Loewe.

Given the uncertainties, most advisers recommend that families earning less than $125,000, who may be eligible for aid, save outside a 529 plan, at least until federal aid rules are made clearer in the next year or so. Families earning $50,000 or less, who are the best candidates for need-based aid, should steer clear of college savings plans altogether and instead focus on building up their retirement accounts, which are exempt from the aid formulas.

What if you have a 529 plan and your child receives a merit-based scholarship or a need-based award? Your qualified education expenses will be reduced by the amount of financial aid. You can get a refund of your 529 money equal to the amount of the award without incurring the 10% federal penalty for unqualified withdrawals, but depending on your state, you may pay income taxes at your rate on the earnings (some states tax these withdrawals at the student's rate). You can also delay 529 withdrawals until your child's final year of school, when the money will not factor into future awards. Other options: You can transfer the money to another family member or you can leave the money invested for graduate school.

You live in a high-tax state with generous 529 tax deductions. If you reside in a high-tax state that offers a serious tax deduction, look closely at its plan even if you are in a low tax bracket. As our tables show, 23 states offer a tax deduction on 529 contributions, including Idaho (top tax rate: 7.8%; $4,000 deduction for a single filer), Missouri (6%; $8,000 deduction per account) and New Mexico (8.29%; unlimited deduction). And 36 states provide a tax exemption on withdrawals. Three states--Arizona, Colorado and New Jersey--exempt withdrawals from out-of-state plans.

You're a grandparent looking to reduce your estate. You can contribute up to $55,000 per beneficiary ($110,000 for a married couple) to a 529 plan without incurring the federal gift tax. That makes 529s a great way to shift a lot of money out of your estate quickly. The $55,000 contribution is counted against your $11,000 annual gift exclusion over five years, so you cannot make another tax-free gift to that child for six years.

LESSON 2: HONOR ROLL

So you've decided a 529 savings plan makes sense for you. Your next step is to figure out which plan is best. A quick glance at our state-by-state tables will make it clear that no two programs are alike. Here's how to make your selection.

Check out your home state. If you're in a high- or moderately high-tax state, a strong deduction may make it worthwhile to stay in your own backyard, even if the plan has higher fees or fewer investment choices than the top plans do. One tip: If you work in one state and reside in another, you may qualify for a 529 deduction on the taxes you pay to the state where you work. Check with your accountant. The 13 plans that we have rated best for state residents are marked with a star in the accompanying tables. These are the states that offer hefty tax deductions for 529 contributions and tax-free withdrawals, as well as solid investment choices and relatively low expenses for state residents who buy directly from the plan.

When investigating your state's 529, check to see if more than one plan is available. As we mentioned earlier, eight states now offer two or more separate 529 savings plans--usually a no-load plan designed chiefly for state residents as well as one or more broker-sold plans. And more states are planning similar moves. You will need to compare carefully to decide which plan, if any, is right for you, since it's not always easy to sort through the multiple options.

For example, New Mexico now offers four 529 savings plans. Our favorite is Education Plan, the lowest-cost option, which is run by Schoolhouse Capital, a subsidiary of State Street Global Advisors. (The plan is also available at a higher cost through advisers or via the Web.) The Education Plan offers portfolios for five age groups consisting of funds from State Street, Janus, Invesco and MFS; you can also hold one of the portfolios as a so-called static investment, which means the fund will not shift allocations as your child ages. But the state also provides three broker-sold plans. Two carry mid-level expenses: CollegeSense, run by Schoolhouse and New York Life, with funds from Mainstay, State Street, J.P. Morgan Capital and Eclipse, and Scholar'sEdge, with Oppenheimer and State Street funds. The latest entry, Arrive Education Savings, which offers portfolios built from Evergreen, Prudential, State Street and SunAmerica funds, levies above-average fees.

Compare out-of-state plans. If you live in a state with low or no income tax, then it makes sense to comparison shop. One important point to keep in mind: If you're considering an out-of-state plan and talking to that plan administrator or your adviser, you may not be told about the tax breaks your own state plan offers--you may even be given incorrect information. In a survey, MONEY reporters called seven brokerage firms and two no-load fund companies and asked about investing as New York residents in an out-of-state 529 plan. Among the brokerage firms, only Salomon Smith Barney's rep stated that New York's 529 plan offered in-state tax deductions, though Fidelity and Morgan Stanley mentioned that residents might get a tax break with their own state plan. By contrast, both the Alliance and Putnam reps said that there were no tax deductions available for 529s. The no-load firms either recommended checking out the state tax benefits (T. Rowe Price) or mentioned that New York's 529 has a tax deduction (Vanguard).

Our four favorite plans--Iowa, the College Savings Plan of Nebraska, New York and Utah--are noted in the tables with an American flag. All four are managed by top investment firms that offer a wide range of portfolios with low expenses. To find the best 529 plan for you, consult the tables with the following guidelines in mind.

Stick with a solid investment manager. Don't put too much weight on the performance history of 529 plans. For one thing, most programs have been around for less than three years, a period dominated by a bear market. Also, while it can be tempting to compare one plan's performance with another, that's almost always an apples-to-oranges situation. The underlying portfolios are different and, as the pie charts in the state-by-state tables show, the asset allocations vary from plan to plan. For example, New Jersey's age-based portfolio for three-year-olds gained 0.1% last year while Maine's option fell 11.4%. But New Jersey's fund holds as little as 60% in equities vs. Maine's allocation of 90%. That's why it makes sense to focus on firms with long-term track records, such as pension plans and retail mutual funds. Among our top picks are Vanguard, Fidelity and TIAA-CREF.

Keep your expenses low. As we noted, more states are selling plans through advisers, and that is driving up fees and sales charges. Good investment advice can be worth paying for, but fees for broker-sold 529 plans can be costly and will eat into the total you save. Some funds offered in Alaska's broker-sold plan, for instance, carry hefty expenses of 2%, plus you may pay a front-end load of 3.5%. That may run you twice the cost of Alaska's no-load plan, managed by T. Rowe Price. And Nebraska's AIM money-market fund shares have hefty expense ratios of 1.06% to 1.81% vs. just 0.61% for the typical retail money fund. "For families whose children are close to college and who are keeping most of their money in fixed-income funds," says financial adviser Michael Steiner of Regent Atlantic Capital in Chatham, N.J., "much of your returns can be wiped out by high plan expenses."

Say a family invested $2,000 in a no-load age-based 529 fund with expenses of 0.65% annually. After 18 years, the account would have grown to $71,152, assuming historical average returns. By contrast, if the family had invested in an identical fund with a front-end load of 3.5%, the account would have grown to $68,662. And if the fund carried an annual expense ratio of 2.3%--standard for many broker-sold funds--that family would have earned only $60,073, 15.5% less than in the no-load 529 with low expenses.

Shop for the right asset allocation, not the largest fund menu. Now that investors can switch 529 funds once a year, states are broadening their investment choices. The typical 529 plan now offers four or five funds, but some states, such as New Mexico, offer 32 options. And some offer more than traditional mutual funds, adding sector funds and guaranteed-return portfolios to the mix.

Still, you shouldn't be overly impressed by a wide array of funds. For most investors, the best choice remains the basic 529 offering: the age-based portfolio that 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 gets older, the equity portion shrinks, so that by the time he or she is 18, the assets are stashed mainly in fixed-income assets, ensuring that the money will be there to meet the first tuition bill. The good news: Twelve plans now offer two or more age-based allocation choices, ranging from very aggressive to moderate to very conservative. Some, such as Maine and Iowa, offer as many as four choices. States with more than one age-based choice are designated in our state-by-state tables with arrows around the pie charts.

If you are a take-charge investor, a plan with five or more fund choices--including large-cap, small-cap and fixed-income--will make it easier for you to design your own asset allocation and then to move the money yourself as your child ages. The risk is that you won't make the right shifts on time. Says financial planner Brian Orol of Raleigh, N.C.: "The value of the age-based fund is that the asset shifts really do take place." Pop quiz: When was the last time you rebalanced your own 401(k) account? If you can't remember--or if, like most people, you have never rebalanced--you would probably be better off choosing an age-based portfolio.

LESSON 3: EXTRA CREDIT

Once you've committed to a 529 plan, evaluate its growth once a year to make sure you're putting enough away to meet your goals. If you are not investing in an age-based portfolio, don't forget to make those allocation moves. If you procrastinate, you may get caught short in a market downturn. That's happened to a lot of families over the past couple of years.

Remember to monitor your 529 plan for changes as states continue to revamp their plans in order to compete with each other. Among the common reforms are enhancing tax breaks, raising contribution limits and switching or adding investment managers.

Bear in mind that 529 contracts with money-management firms generally last from three to eight years. If a state is not happy with the performance of the manager, or if the plan is not attracting sufficient assets, you can expect some kind of overhaul. North Carolina, for example, recently added more funds as well as an adviser-sold plan run by Seligman. It's worth repeating that moves like this could result in improved fund choices but almost certainly higher fees. "A 529 plan needs to reach a critical mass in assets to break even, and a few states are even getting a share of revenue from these plans," says Joseph Hurley, head of Savingforcollege.com and author of The Best Way to Save for College.

When it comes time to make withdrawals from your 529 account, plan ahead. If you qualify for a hope tuition credit or lifetime learning credit (fully or partially available to married couples with combined incomes of up to $102,000) or for a section 222 tuition deduction (incomes up to $130,000), be aware that you can't double-dip--that is, if you use a particular education expense to claim the credit or deduction, that expense no longer qualifies for a 529 tax-free withdrawal. So unless your education costs are sizable, you may have to forgo the tax break or leave your 529 intact for future spending. But chances are, given the constant rise in college costs, generating enough bills to pay won't be a problem.