Here's a step by step process for creating a shirt. The process is used pretty much the same way with any article of clothing.
Step One
Open Photoshop. Along the top of the screen there will be a series of pull down menu listings: File, Edit, Image, layer, Select, Filter, View, Window, and Help. The one we want to start with is File.
Step Two
In File, select New. That will open up a new blank canvas, but first it will give you a popup asking what you want the canvas to look like. The settings should be set as follows:
Width and Height: 512
Resolution: 72.009 pixels
Mode: RGB Color
Background: white
Once those are set, click Ok. That will open your new canvas.
Step Three
Now go up again to File, and select Open. Open up your Upper Body template and the fabric you want to work with. Both of these should also be set, on the popup, as above in Step Two.
Step 4
Make sure you have your Layers Workbox visible. To do this, if it doesn't open automatically, go to Window, and select Show Layers. Do the same with your Tools box.
Step 5
Click on your blank canvas, and go up to the Layer menu up top. Open that and select New Layer. That will create a new layer, called Layer 1. Do this a second time to create a second Layer, Layer 2.
step 6
Once both of those are completed, click on your Template image. Go to the Select pulldown menu, and click All. Go back to your blank canvas, and click on the Layer 1 selection. Go up to Edit, and hit Paste. That will put your template onto the first layer.
Step 7
Do the exact same thing with your fabric image, which will go on Layer 2. When you first create the layer, you'll get a popup asking for a set of options. The second layer should be set this way:
Group with previous Layer: Unchecked.
Color: None
Mode: Normal (Some people use Multiply for lighter colors, either works)
Opacity: 50%
Setting the Opacity to 50% will let you see the template under the fabric.
Step 8
Okay, now that you have your layers up, it's time to start designing.
Click the Magic Wand tool. Once you have that clicked, look up at the top of the screen, toward the Menu bars. Just under Select you'll find a small box called Tolerance. Type 25 in there. Also, click the boxes for Anti-aliased and Contiguous. Both of these should be checked to avoid having the Magic Wand tool have an orgasm trying to grab the whole image on the template.Step 9
Using the magic wand tool, select back on Layer 1 and click somethere outside of the minimum bleed through lines, on the white area. It will select a small portion of the image. Hold down the shift key, and click everywhere else outside of the template.
Step 10.
Click on the second layer again, go to Edit, and select Cut. This will get rid of everything outside of the template.
Step 11
Now you're ready to actually design. Using the paintbrush tool or the Eraser tool, scrub away at the fabric left on Layer 2 until you get the design you want. Use the lines provided on the template to get a general idea of where your seams are and note the minimum bleed areas: you don't want to erase over those if that's where a side seam will be because keeping those filled in will help eliminate "seam bleed", where your avatar's skin leaks through the fabric. I like to use a hard round brush for neater, even lines. You can also get good straight lines with the Marquee tools. These are found in the upper left hand corner of the Toolbvox, it looks like a square made of little dashes.
Step 12
When your design is finished, click on Layer 1 again. You'll see a little eye icon to the far left of this layer, that allows it to be turned on or off. Turn it off. That leaves only the second layer visible, our fabric.
Step 13.
On Layer 2, click outside the fabric color with the Magic Wand tool again. Using the same method as before, hold down the shift key and click everywhere in the white. You may get a few 'stray' spots, those are easily fixed by going to View, then Zoom in, and still holding the shift key clicking in these areas. Now is also a good time to clean up any floating fabric bits you don't want that you may have missed.
Step 14
Go back up to Layer, and create a new Layer. This is Layer 3, and will be your Alpha Channel Layer. Make sure the Mode is Normal and the Opacity is 100%. Click on this, and then select your Paintbucket tool. Fill the selected areas with black. Once that's done, click inside the fabric itself with the Magic Wand tool and hold down the shift key if you need to to get everything. Use the paint bucket tool again to fill this area with white.
The stuff that's white is what will be seen on Second Life. Black stuff is disgarded. Also, to make transparent garments use grey instead of white. The darker the grey you use, the more see through the fabric will be on your avatar. And don't worry, coloring the white areas grey will not affect the color of your fabric once you wear it.
Step 15
Go to the Select Menu and click All. Then open the Edit menu and select Copy.
Step 16
Looka t the top of your Layers box and you'll see a series ot overlapping tabs: Channels, Paths, History, and Options. Channel is the one we want, so open that one. This shows you all the colors that Photoshop currently sees: Red, Blue, Green, ect. If it doesn't already have a channel called Alpha, create one by looking down at the very bottom of the box. You'll see a pair of overlapping boxes. Click that to create the alpha channel, and then Paste the layer three copy here.
Step 17
Go back to your Layers drab, and delete the third layer by dragging it down to the little trashcan icon at the bottom. Go back up to Layer 2, and set the Opacity back up to 100%.
Step 18
Go up to the Layer pulldown menu, and look all the way down to the bottom to where it says Flatten Image. Photoshop will ask you if you want to discard the hidden layers. Click Yes.
And now you're ready to uploade your new clothes!
The last thing to do is go to to File, Save as. Name the image and save it as a Targa file ( .tga). Photoshop will ask you what 'bits' you want to save this in. Select 32. Then it's just a matter of logging into SL, uploading the design as a texture, and putting it on. 
