Final answer:
An employee can claim exemption from withholding if they had no tax liability the previous year and expect the same for the current year. This exempts them from federal income tax being withheld but not from Social Security and Medicare taxes. To claim this exemption, they must complete Form W-4 following the IRS guidelines.
Step-by-step explanation:
An employee may claim exemption from withholding if, over the previous year, the employee had no tax liability and expects the same for the current year. This means that the employee did not owe any federal income tax and anticipates the same situation. Those who can claim exemption from withholding will not have federal income tax withheld from their paycheck, including pay-as-you-earn tax (PAYE), or pay-as-you-go tax (PAYG).
It's important to note that exemptions from withholding do not apply to Social Security and Medicare taxes. Most employees will see payroll taxes such as the 6.2% for Social Security and 1.45% for Medicare deducted from their paychecks. An exception to this could be certain groups like qualifying religious sects who, based on specific criteria, might be exempt from paying these taxes. Independent contractors, however, must pay both the employee and employer side of these payroll taxes.
To legally claim exemption from withholding, an employee must complete Form W-4, claiming the exemption by following the IRS guidelines. Incorrectly claiming exemption can lead to interest and penalties from the IRS, so one should ensure they meet the criteria before filing as exempt.