That is pretty much what I thought. I am going to have my wife get a copy of her W4 tomorrow to make sure.
Speaking of W4.
What is the most appropriate way to fill them out anyway? I've heard different things and I'm just not positive.
We're married, live in a house and have no dependents (1 on the way though).
If you can swing it. I'd suggest having your wife (assuming you are the main wage earner) do the following: Fill out the W4 with 0 exemptions, and have them withhold at Married, but withhold at the single rate. My guess is you'll end up at about "even" at the end of the year. Your wife will basically be taxed as a single taxpayer with no dependents. The tax rate will be higher, but if you don't want to come up with money at the end of the year, it's a pretty painless solution.
As far as the zero fed tax withholding, there isn't much she can do. She can complain to her employer, but they'll probably apologize. The only good thing is (and I know it still sucks) is that they paid her the taxes and didn't screw the IRS out of them. Also, be sure she gets itemized paycheck stubs so that you can be sure they're doing what she has asked. Another thing is that she can change her withholdings at any time during the year if you need to make adjustments to her withholdings.