My wife (36 years old) worked for State Street Bank in Massachusetts for six 6 years and qualified for Pension benefits. In 2006, she borrowed $7000 against her 401k in State Street Bank to remodel the home. She left SSB in the summer of 2006 for another job. In February 2007, she asked for a $9500 lump-sum distribution of the Pension from SSB and then paid off the loan ($6000 remaining) she had against her 401k.

My question is: Would she incur an early distribution penalty and how much tax she has to pay considering she paid back most of the pension money to the 401k loan?

Thanks,
Bao

Yes, she would incur early withdrawal penalty of 10% of $9500. Also this money will be taxed as her regular income.

Can we consider $6000 she paid back into her 401k loan a direct rollover to an IRA, and she can only be taxed and penalized on the remaining $3500?

She borrowed from 401K and paid back, no implication.

She withdrew from 401K with out any qualifying reason, it is subject to Early withdrawal penalty.