State college savings plans--a.k.a. 529 plans--are back in vogue, with families contributing 75% more to these accounts in 2010 than in 2008, according to Financial Research Corp.

The main appeal of a 529 is income tax savings: You put money in one of these plans and you don't have to pay federal or state income tax on the earnings, provided the cash is withdrawn to pay for college or graduate school tuition, fees, room and board, or books. In some cases you also get a state income tax deduction for your contribution.

There is, however, a whole other set of benefits and traps that parents and grandparents should understand.

### The emergency fund

Normally, to get money out of your taxable estate, you must relinquish any claim to it. But 529s have a special advantage: Funds you put into them are out of your estate, yet you can take back the money if you want to or switch the beneficiary from one child to another. This appeals to Carlyn S. McCaffrey, a lawyer with McDermott Will & Emery in New York. Known for the sophisticated trusts she sets up for superwealthy clients, she favors 529s as "a convenient and easy way" to provide for the education of her own three grandchildren. (Easy, that is, compared with a trust.)

If you think you might need to take the money back, you must name yourself, not an adult child, as the "owner" of the account, points out Susan T. Bart, a lawyer with Sidley Austin in Chicago. Keep in mind, however, that if the funds aren't used for education, any earnings that are withdrawn are subject to ordinary income tax and a 10% penalty.

### College financial aid

If a grandchild might qualify for financial aid (parents earning as much as $200,000 could qualify if they have two kids in private colleges at the same time) ownership of a 529 gets trickier, warns Joseph F. Hurley, a CPA who compares plans at www.savingforcollege.com.

The Free Application for Federal Student Aid (known as FAFSA) doesn't ask about 529s owned by a grandparent. But if a grandparent-owned 529 makes a distribution for tuition, that amount counts as income to the student on the following year's FAFSA. Since a student is expected to apply 50% of all income above a certain amount to college expenses, a well-meaning grandparent could exhaust a 529 in paying the first year's tuition and at the same time endanger a student's ability to get aid (including subsidized federal loans and work-study money) the next year, says Hurley. In such a case the 529 funds would be best spent paying senior year tuition.

But wait. It gets even more complicated. About 250 of the most expensive private colleges (including members of the Ivy League) use the College Board's Profile form to award their own aid (meaning price discounts). This form requires the student to report all 529 savings accounts that name him as a beneficiary and that aren't owned by his parents. Such accounts could have a big impact on a grandchild's eligibility for aid from these schools.

No matter which forms you fill out, you may be able to mitigate the impact on aid by transferring ownership of the account to the student's parent a year before the student applies for college. Then, assuming the student is a dependent, the 529 would count as any other parental nonretirement accounts; 5.64% of the balance is expected to be used for college each year, but distributions from the 529 aren't income to the student or the parent.

Could the transfer of ownership be a taxable gift to the parent? Bart doesn't think it is but notes that the Internal Revenue Service hasn't ruled on the issue.

### Naming a successor owner

This person will call the shots on investments and distributions of the 529 if you pass away before the beneficiary goes to school. Grandparents setting up a 529 will generally want to name each other and then the child's parent as the successor.

Young parents who establish a 529 for a child will generally do well to name the other parent as the successor owner. Should one parent die prematurely, the survivor has control of the money as successor owner--and can tap it for noncollege needs. If the survivor doesn't touch the money, it won't be counted as part of either person's estate.

What if you don't name a successor? The answer depends on the terms of an individual state's 529 plan, Bart says. It could be the beneficiary of the plan, if she is older than 18, or the executor of your estate.

### Avoiding gift tax

You can give anyone (and everyone) $13,000 annually without eating into your lifetime exemption from gift or estate tax. (That exemption is currently $5 million but under current law will fall to $1 million in 2013.) When it comes to 529s, however, there's a special twist: You can make a lump-sum deposit of as much as $65,000 ($130,000 for a couple) and treat it as five years' worth of annual $13,000 gifts. To do this you must file a gift tax return, and if you die before the five years is up a pro rata part of the gift goes back into your estate. Still, it's a good way to get a large lump of college money into a 529, where it can grow tax free.

### Custodial account conversion

People who have put college savings in a Uniform Transfers to Minors Act (UTMA) account for a child may want to convert it to a 529 for the extra income tax savings, Bart says. But the conversion must be into a special "custodial 529" and won't solve a problem with all UTMA accounts, which is that children gain legal control over the funds once they reach the age of majority under state law (usually 21, but sometimes as young as 18). So the money could be blown on something other than college. Another catch: Since 529 accounts can be funded only with cash, you'll have to liquidate the holdings in the UTMA, which could mean paying tax on any gains.