Disclaimer: I am not a tax accountant, tax attornet, or tax professional of any kind.

elbaso's answer seems pretty much on target, with a couple of caveats/corrections.

The first is trivial. The withholding form you fill out for your employer is the W-4, not the W-2 (that's the statement of income you get from your employer each January). I assume this was just a typo.

The second is more serious. Ideally, you'd like to adjust your withholding so that you neither get a refund nor owe any money at tax time. Over-withholding gets you a big refund of money that you essentially lent to the government interest-free. Under-withholding, on the other hand, may subject you to interest and penalties in addition to the tax you owe. This is because the IRS expects you to pay taxes more or less as you earn money. This is why the self-employed and those with substantial non-salary income often make quarterly estimated tax payments. If you under-withhold, make sure you don't do it by too much. The definition of "too much under-withholding" varies year to year, so consult the IRS or a tax pro, but you are typically safe if you withhold *at least* as much as you owed in taxes the previous year.
Source(s):
Here's a good summary:

http://www.bankrate.com/brm/itax/Edit/basics/Introduction/basic_3a.asp


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