re: So the wife quit her teaching gig, and...

I think if you do #2, the penalty is 35%. They'll withhold 25% for taxes and make you pay a 10% penalty. Of course if you're in lower tax bracket than 25%, you'd have to wait until you file your taxes to get the refund. If you're in a higher bracket, you'd have to pay more when you file your taxes to make up the difference.

I just looked it up in my Becker CPA review book, and you avoid the 10% penalty if you're a first time homebuyer (limited to $10K), medical insurance if you're unemployed or self-employed, medical expenses in excess of 7.5% of AGI, diability, education for college tuition books & fees, or death. So I think you'd pay the 10% penalty if you used the money to pay down student loans. Now if you're going back for a degree, there'd be no penalty. Our government make a lot of sense.