Major Illness or Injury

Although everyone knows medical expenses are deductible, in truth very few taxpayers actually get to deduct them.

The catch? You must itemize deductions to write off medical expenses, and only about 25 percent of taxpayers itemize. Such costs are deductible only to the extent they exceed 7.5 percent of your Adjusted Gross Income (AGI). So if your AGI is $50,000, the first $3,750 of unreimbursed medical expenses don't count.

If you, your spouse or your dependent children are facing a major illness or injury, however, you may well surpass the 7.5 percent threshold. If so, be sure you total up all your qualified expenses.

If you have a Health Savings Account or an Archer Medical Savings Account, withdrawals used to pay qualifying medical expenses are tax-free.

Generally, employees are allowed to adjust the amount of salary earmarked for a medical reimbursement account only once a year. If during your "open season" you anticipate higher medical bills in the year ahead, consider increasing your set-aside.

Salary diverted into a reimbursement account and then used to pay medical bills escapes both income and Social Security taxes. There is no legal limit on how much can be set aside but most companies set a limit of $5,000 or less per year. A $5,000 set-aside that avoids a 25 percent federal income tax rate and the 7.65 percent Social Security and Medicare tax would save you more than $1,600. Any state tax savings would make this an even better deal.

Although using retirement funds for anything other than retirement is generally discouraged, crushing medical bills could force you to tap your account. If you tap a traditional IRA before age 59½ , the 10 percent penalty that normally applies to payouts before age 59½ is waived to the extent that you have qualifying medical expenses in excess of 7.5 percent of AGI. The same goes for early withdrawals from 401(k)s, although such withdrawals are difficult to make if you are still on the job. "In-service” withdrawals are only allowed if you can meet hardship requirements. If you have left the job in a year in which you were age 55 or older, the 10 percent penalty doesn’t apply regardless of the 7.5 percent rule. Even if you avoid the penalty, your IRA or 401(k) withdrawals will be taxed as income.

If your condition results in your receiving benefits under a disability insurance policy, the taxability of the income depends on who paid for the policy. If you paid, the benefits are tax-free. If your employer paid for the insurance, the benefits are fully taxable.

If you receive a settlement in a damage suit that includes money for medical expenses you deducted in an earlier year, that amount is considered taxable in the year you receive it, but only to the extent that the deduction actually reduced your taxable income for the year you wrote off the expenses.

If a settlement includes funds for future medical expenses, the amount is not taxable, but neither are those future medical expenses deductible until they exceed the amount of the award allocated to future medical care.

TurboTax has the tax information you need to take advantage of tax breaks to help pay medical expenses.

Updated for tax year 2008