The amount your employer withholds from your pay is determined in large part by the information you provide on your W-4. Generally, you are only allowed to claim an exemption from withholding if you had a right to a refund of all federal tax withheld during the previous tax year, and you expect a refund of all tax withheld for the current tax year. For example, to claim exempt on your taxes in 2011, you must not have had any tax liability for tax year 2010, and you must anticipate that you will not have any tax liability for the 2011 tax year. However, if your earnings are substantially higher in 2011 than in 2010 or you experienced a significant change in your tax situation that impacts your withholding, you are not eligible to claim exempt as your status.
To better understand whether your earnings require you have federal tax withheld from your earnings, log on to the IRS website and use the withholding calculator. The calculator will prompt you to answer a series of questions about your tax situation and provide you with an estimate of how much (if any) tax should be withheld from your pay. If the calculator estimates that you are responsible for paying federal tax, it is in your best interest not to claim exempt so that you don't owe tax at the end of the tax year. You can also use chart 1-B in IRS Publication 505 to help you determine whether you are eligible to claim exempt.
Claiming exempt on your W-4 does not exempt you from paying Medicare tax or Social Security tax. These are separate payments and are not impacted by your decision to exclude yourself from paying federal withholding. In addition, you are not allowed to claim exempt if you earn in excess of $950 and that income includes more than $300 from unearned income.
If you claim an exemption but your situation changes later in the year, you are required to file a new W-4 within 10 days of the change.