When you enter the information from your Form 1099-R and come to the screen asking if the funds were used for medical expenses, the amount that was used to pay for medical expenses over and above 7.5% of your Adjusted Gross Income will be exempt from the 10% early distribution penalty. The distribution will still be subject to income tax. The medical exception is for the penalty only.
If you do qualify to be exempt from the penalty, then you can also deduct the medical expenses as part of your itemized deductions. This is because the money used to pay the medical expense is being taxed, therefore the expense can be deducted.
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