As American families grapple with increasing health insurance premiums, many are looking for ways to reduce costs without sacrificing their medical coverage. Consumer directed health care options can be used to reduce monthly premium payments, and to pay for medical expenses with tax-free dollars.

Basics of consumer directed health care

Consumer directed health care encourages consumers to take a more active role in their medical care. One defining feature of consumer directed health plans (CDHPs) is a high deductible. By requiring families to pay greater out-of-pocket costs, these plans can keep health insurance premiums low. In addition, they provide incentive for individuals to maintain good health habits and seek out cost-effective treatments.

Although aspects of consumer directed health care have been around since the late 1970s, it wasn't until the creation of Health Savings Accounts (HSAs) in 2003 that interest began to take off. According to the industry publication Inside Consumer-Directed Care, enrollment in CDHPs was projected at 1 million to 1.3 million in 2004. The American Association of Preferred Provider Organizations reports that number jumped to 28 million by 2010.

Helping to fuel the popularity of CDHPs are the government-approved accounts that allow members to pay for medical expenses tax-free. These include HSAs, health reimbursement arrangements (HRAs), flexible spending arrangements (FSAs) and Archer Medical Savings Accounts (MSAs).

Health Savings Accounts (HSAs)

As CDHPs become more readily available, the use of HSAs tripled from 2008 to 2011, according to a census by America's Health Insurance Plans (AHIP), an insurance industry group. Overall, enrollments in these accounts have grown from 1 million in March 2005 to 11.4 million in January 2011.

HSAs allow individuals to save money to pay for approved out-of-pocket medical expenses. The money deposited in the account is not subject to taxes, and any interest that accumulates is also tax free. In addition, the account total rolls over from year-to-year allowing individuals to save a substantial amount for future medical expenses. HSAs are portable and can be maintained even if you change jobs or leave the workforce.

According to IRS guidelines, an HSA must be tied to a high-deductible health insurance plan that has a minimum deductible of $1,200 for individuals and $2,400 for families. As of 2011, individuals are allowed to contribute up to $3,050 tax-free to their account each year. Deposits for family accounts can equal up to $6,150.

Health reimbursement arrangements (HRAs)

HRAs operate similarly to HSAs but with an important distinction. While HSAs are employee-owned accounts, HRAs are set-up by employers on behalf of their workers. Only the employer can contribute to the account, from which an employee can withdraw money for approved medical expenses.

Some employers may require HRAs to be used in conjunction with a high-deductible health plan, but there is no legal requirement to do so. In addition, there is no limit to the amount an employer can deposit in an HRA. However, employers also get to decide whether the account balance rolls over each year, and upon the end of employment, any remaining funds generally revert back to the employer.

Flexible spending arrangements (FSAs)

Created by Congress in 1978, FSAs are one of the oldest consumer directed health care options available. These arrangements--sometimes called flexible spending accounts--are created by employers to allow their employees to pay for approved expenses using tax-free dollars. The IRS doesn't place a specific limit on the amount that can be contributed to an FSA, but the agency notes the arrangements must prescribe a maximum amount for health expenses.

A benefit of FSAs is that money allocated to the account can be used in advance. For example, if you have a large medical bill in January, you can be immediately reimbursed the entire amount, up to your annual contribution. However, participants must carefully estimate their expected out-of-pocket costs because any amount not used by mid-March of the following year is forfeited and returned to the employer.

Archer Medical Savings Accounts (Archer MSAs)

Designed to help offset medical expenses for self-employed individuals and small businesses, Archer MSAs are being slowly phased out in favor of HSAs. For most individuals, 2007 was the last year to open a new account. However, those with an existing account can continue to make contributions and withdrawals.

Like HSAs, individuals with an Archer MSA must also have a high deductible health plan. However, the minimum deductible required by a MSA is greater--$2,000 for individual plans and $4,050 for family plans. Contributions to an Archer MSA are limited based upon your deductible as well as your income.