I am receiving a layoff in 1/2010 from a company. I have approximately $114000 in a 401k account which I'm considering having distributed. I'm very far from reaching the penalty avoidance age of 55. Fidelity Investments is the plan's manager. If I decide to take a lump sum distribution and I say I'm using all funds for higher education, will Fidelity probably mark my 1099-R with that associated code? Will the IRS actually confirm I used it for that purpose? What if I change my mind and don't use the money for that purpose? How does the IRS track the higher education use of 401K money? Would I be assessed a penalty on top of the 10% early withdrawal penalty?

Actually, using the money for higher education does not relieve you of the 10% early withdrawal penalty. There is often some confusion about this - higher education expenses are defined as a "hardship," which means that your plan must allow you to withdraw funds for this purpose - but being a "hardship" does not mean that you aren't subject to the penalty (or income taxes).

One thing to consider is this - roll your 401(k) to an IRA, then make a withdrawal from there. Withdrawals from IRAs used for higher education DO qualify for an exception to the 10% penalty. Go figure. However, I suspect that the IRA custodian would want to see the tuition bill from your school before they would certify that the money was used for this purpose.

Remember also that the amount you withdraw will be taxed as income regardless of how you use it.
The 10% penalty is just an extra little incentive for you NOT to withdraw these funds.

It is MORE than a LITTLE incentive to not withdraw, considering that the 10% penalty cannot be mitigated, meaning that, after all credits, deductions and exemptions are factored in, you will STILL owe the 10% penalty.