She is actually a retired teacher. She retired Dec 31, 2011. Why would that keep her from having to pay penalties on the loan or did I misunderstand?

When did she turn 55? If she turned 55 in 2011, it would keep her from paying penalties on any of the withdrawal, not just the loan.

There is an IRS rule that allows withdrawals from a 401(k) to be penalty-free if one leaves the service of the employer sponsoring the 401(k) in or after the year one turns 55. Unfortunately, my guess is that she retired 1 day too early to take advantage of this, since she probably turned 55 in 2012, but retired in 2011. That means she will owe penalties on any withdrawals until she reaches 59 1/2.

AJ