We have $20,000 in education cost in 2008 and a loss on our personal business. We are considering withdrawing the $20k or more to pay off the house. IF we withdraw more than $20k we will have to pay the 10% penility on that amount but with the business loss we would not be paying additional fed and state taxes. This 401k is a rollover and we are no longer with the company to get a loan. Are we correct that we would not have to pay the penility on the $20k for the education expenses? Is the documentation we need just receipts?

Sorry, but you have misread the law. Withdrawals prior to age 59 1/2 are only allowed under a limited set of circumstances. One of those circumstances is to pay for education. However, while that reason allows you to withdraw penalties still apply.

In addition, the plan will withhold 20% against your tax liability.

The only way that you would eliminate owing taxes on the withdrawal is if your business has a $20K loss over and above any other income. You would still have to pay the 10% penality.

This site may help you understand.
401khelpcenter.com - Hardship Withdrawals Give Access to Your 401k Savings, But at a Cost