Since it sounds like you want to keep your medicine cabinet I'd go with option one. Though I might add a fourth option if you can find some of the decorative track lighting instead of recessed lights that you like.

Who will be using the bathroom and for what purposes? I'm asking because the options you list give very different types of light. If anyone will be applying make-up, then you should go with the side lights. Down lighting is notoriously unflattering. To get the best light (ie, most flattering) the lights should be mounted at eye level.

Are there any other options for the medicine cab? could you do small shelves recessed into the studs? Sounds difficult, but they sell these prefab that you just cut into the drywall, insert and finish.

Would a different medicine cabinet that opened in the opposite direction work?

Agree with Daisy that downlighting is unflattering and tends to cast shadows. I think all bathroom mirrors should have side lighting.

Thank you all for your helpful suggestions! Justgotabeme, I hadn't thought of using track lighting. That's worth investigating.

Daisychain, our kids use this bathroom. Our girls aren't old enough to wear make-up but, of course, in time they will be and the medicine cabinet would be useful for storing make-up. Right now it is mainly used for housing toothbrushes. We could put a toothbrush holder on the counter but most of them are designed to hold four toothbrushes. We have five kids. The built-in shelves are an interesting option but I'm afraid they would end up looking messy.

Natal, I like your idea of opening the medicine cabinet in the opposite direction. It is a really cheap thing held in by just two screws. I think I can turn it upside down and try it that way to see how it works. It might still hit the side light when swinging open but it's worth a try.

The main thing we need to decide right away is whether to remove the lighting box above the mirror. If we go with overhead or side lighting, do you think it would look better if the box opening were covered with drywall or the entire box removed?

Just joining in here - really like the advice that daisychain had to offer. Definitely go with the side lighting - your girls will thank you as they get older. I say get rid of the lighting box and let the wall go to the ceiling.

Good luck!

Thank you for your post, Dalmadarling. I'm leaning that direction too, if the medicine cabinet door will clear. It is great to have all of your input.

Agree, get rid if the light box!