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If you claim exemption from withholding, your employer will not withhold federal income tax from your wages. The exemption applies only to income tax, not to social security or Medicare tax. You can claim exemption from withholding for 2009 only if both of the following situations apply.
For 2008 you had a right to a refund of all federal income tax withheld because you had no tax liability.
For 2009 you expect a refund of all federal income tax withheld because you expect to have no tax liability.
If you receive not regular payment that is treated as supplemental wages - federal tax are normally withheld at the flat rate 25%.
It would be exempt from withholding if you file W4 form as EXEMPT.
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The IRS expect us to pay taxes as the income is received.
If you do have tax liability - you may not decide not to have tax withheld and pay all tax liability at the tax time.
Your employer is required to withhold income taxes based on your W4 filing.
You may only file EXEMPT on your W4 form if both qualifications - see above - are met - and you do not expect any tax liability.