Ms Wood, a federal judge, had been cited by senior administration officials as Mr Clinton's near-certain choice even yesterday, when the officials said she would be named unless problems developed during an FBI background check.
Two other finalists for the post were said to be the Washington attorney, Charles Ruff, and the former governor of Virginia, Gerald Baliles.
In a statement issued by her lawyer's office, Ms Wood said she had done nothing illegal. 'I have fulfilled every legal requirement with respect to the employment of our babysitter. Nevertheless, and after further consultations, I have concluded that in the current political environment, proceeding further with the possibility of my nomination would be inappropriate.'
Ms Wood was the second woman from the President's list to withdraw. Ms Baird, President Clinton's initial nominee, pulled out last month because of a public outcry over her hiring of illegal aliens.
Ms Wood said she hired her babysitter in March 1986, and had paid all required taxes and filed all required forms. 'In March 1986, it was lawful to openly employ aliens who were in the country, like my babysitter, on an expired visa as long as all required taxes and forms were filed,' she said. 'However, although all my acts were lawful, my babysitter, like anyone pursuing legalisation, was not legally in this country from 1980 until she obtained legal residency in December 1987.'