The final payment is about 50% due at project completion hopefully in Feb2023. We used her 401K funds to pay for the down payment.
Home improvements that are medically necessary are only deductible as medical expenses on schedule A if they do not raise the value of the home. If they raise the value of the home, they are added to the cost basis, and may reduce your capital gains when you sell, but they are not deductible when paid.
To find out if your bathroom remodel would add to the value of the home or not, you may need to consult with a real estate professional.
If the improvement will not raise the value of the home, then you deduct the medical expense in the year you actually pay it. If you split the payment across two years, you would deduct it in those 2 years.
If you deduct the cost as a medical expense, you can't also include the cost of the improvement in your cost basis when you later sell the property.
The source of the funds doesn't matter for the medical expense deduction.
If your wife is under age 59-1/2, her 401k withdrawal will be subject to a 10% penalty for early withdrawal, unless she was 55 years or older when she separated from service with the employer who sponsored the plan. If you use 401k funds to pay for medical expenses that are more than 7.5% of your adjusted gross income, that portion of the withdrawal is exempt from the 10% penalty (but not the entire withdrawal).