I'm not sure the other way is 'technically not legal'. I know there are rights restrictions on music, but I don't believe doing this with your own music yourself is not legal. Its fully unsupported by Apple though...
Another way to look at it is this: If you're copying royalty free music to your iPhone, that in itself is deffinately legal...
Also, I have a fried who is a musician (and his own label) who does happen to be available on iTunes. I used one of his songs for his custom ringtone on my phone (not the iTunes version, but rather one I ripped from an actual CD I bought from him). Being he fully holds the rights to his own music (outside of the DRM'd version which he used a third party to release), it was fully legal for me to do so with his blessing...
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Also, isn't it true that current methods don't work for iTunes protected music?
I think the reason for the $.99 is more dependent on the fact that most ringtone selling outlets do charge an arm and a leg for ringtones. I think the additional $.99 charge is the only way Apple could get artists & labels to sign on to this feature...