My gut reaction is that she deserves to know the truth. You tell her that her daddy loves her, but she never gets to see him. That's got to be confusing. She may wonder if he's staying away because of something that she said or did.
But while you're telling her the truth, stick to facts, not opinions. Don't say that her daddy is "bad." Tell her that Daddy is in jail because he made some really bad choices and he broke the law. (You don't have to be too specific if she's not developmentally ready to hear what he did, like if he committed rape or something). It's okay to teach her that actions have consequences and that people who choose to break the law--no matter who they are--have to go to jail.
