Taxes on pensions depend largely on the type of pension you receive. A defined benefit plan is a pension that provides a set dollar amount for your retirement income. The employer fully funds this retirement plan. A defined contribution plan is a retirement plan in which you or your employer contributes a set dollar amount, but no benefit payment is guaranteed at retirement. One may be subject to inheritance tax while the other isn't.
A defined benefit plan is the traditional pension plan. This pension plan may offer a beneficiary payment option, i.e., when your spouse dies, you receive the remainder of his pension. This amount is normally not subject to inheritance tax or to the federal estate tax. A defined contribution plan, on the other hand, is more like a 401k plan, 403b plan or some other retirement plan in which retirement income is not guaranteed.
You may receive a pension from your spouse and not have to worry about paying additional inheritance tax on the pension payment. Your spouse may choose to give you 100 percent of her pension income after her death. This allows you to pay all of your normal monthly expenses, assuming that these expenses do not change. Additionally, if you inherit your spouse's 401k plan or other defined contribution plan, you may not pay estate taxes on it as long as the estate is less than $5 million. Your state may also not assess inheritance tax on transfers to spouses.
Nonspousal inheritances are treated very differently from spousal inheritances. If your state assesses an inheritance tax, you'll pay this on any defined contribution plan you inherit. This leaves less money for you, and may make it more difficult to pay for funeral and final expenses if your loved one did not have enough life insurance in force at his death.
You should make sure that your spouse or loved one has made plans prior to her death. A good estate plan minimizes taxes on money transferred to heirs. Consider a life insurance policy inside a life insurance trust. The life insurance policy may offset any inheritance taxes due on a retirement plan. Also, transferring property out of your loved one's name and into a trust, or into your name, reduces the property in your loved one's name. This, in turn, reduces the impact of inheritance taxes.