As you probably know, the primary difference between a Roth 401(k) and a Traditional 401(k) is in how the two kinds of employer-based plans are taxed.

With a Roth, you pay taxes up front (i.e., before the money is contributed) and therefore you can take tax-free with withdrawals in retirement. With a Traditional 401(k), you avoid the upfront taxes but are taxed on withdrawals.

But as with almost everything else related to taxation, there is an exception (surprise!) to the general rule. That exception could mean some of your Roth 401(k) withdrawals will be taxed after all.

It all depends on whether a portion of the money in your 401(k) is from employer matching funds. The money you put into a Roth (and the related earnings on that money) will not be taxed on withdrawal, but any money your employer provided to match your contributions will be taxed, as will any investment earnings derived from those matching funds.

Why? Because your employer wasn't required to pay taxes on that money before making the matching contribution. So at some point (i.e., when the money is withdrawn), Uncle Sam will be waiting. Strictly speaking, the employer match isn't invested in a Roth account at all, but in a traditional 401(k) that serves as a "companion" to your Roth account. 

The company that holds your retirement funds is required to provide separate tracking of your contributions (and related earnings) and the employer match (and its related earnings), such as shown below. The first pot of money will be tax-free upon withdrawal, the second will be taxed as ordinary income.

"Most everyone I talk to is shocked by this and surprised," says Sean Stein Smith, a CPA who's also a professor of business and finance at Lehman College in New York. Unfortunately, the taxation of the employer match (and related earnings) is rarely highlighted in articles that discuss the tax treatment of Roth 401(k) accounts.

So would it be better not to have a match? Of course not! A 401(k) employer match is a terrific benefit, as we noted in our October 2017 SMI newsletter article, Your Employer-Sponsored Retirement Plan. If a match is available to you, we urge you take full advantage of it!

Just be aware that the IRS will treat a portion of your Roth account funds (possibly a substantial portion) as a pay-tax-when-you-withdraw Traditional 401(k), rather than as an after-tax Roth 401(k).