By Roger Conrad on May 25, 2012

Unless Congress and the president act, the top federal tax rate on dividends will rise to 45 percent on January 1, 2013. That possibility has set off speculation of an impending Taxmageddon, during which dividend-paying stocks will crash by a third or more as investors adjust their portfolios to offset the effect of higher tax rates.

Dont count on it. There may indeed be knee-jerk selling of some high-yield stocks, if enough investors are convinced of an impending cliff. But whatever damage is felt will almost surely be quickly reversed, so long as the underlying companies stay healthy.

For one thing, dividend tax rates are unlikely to rise that high. The trading action at the online political futures exchange Intrade still shows President Obama with a better than 60 percent chance of winning another four years in the White House. But its also consistently given at least equal odds of the Republicans capturing at least one house of Congress, and quite possibly both.

That makes it extremely unlikely one party will hold all the levers of power, including the 60 votes in the US Senate necessary to invoke cloture and effectively impose one-party rule. And that means a grand compromise on budget and tax issues after the November election is far more likely than any politician will admit. A deal would almost surely bring higher dividend tax rates for at least some Americans. But theres considerable room between 45 percent and 15 percent to soften the blow, at least for most.

Second, even if rates do rise, they wont likely affect valuations on dividend-paying stocks. The Federal Reserve Boards Finance and Economic Discussion Series analyzed the market impact of the Bush tax cuts on dividend-paying stocks in 2003 when they were enacted, and found the following:

• The passage of the dividend tax cut had little if any impact on the overall stock market.
• The small boost high-yield stocks received from the dividend tax cut was quickly reversed by other factors.
• Real estate investment trusts (REIT) dropped on the day the bill was signed, as they received no benefit from the legislation. But they fully recovered within days and went on to be a top-performing, dividend-paying asset, until the property market crashed in 2008-09.
• Many US stocks were actually held in tax-deferred accounts, for which the lower tax rate did not apply.

Recently, Miller Howard Investments took these findings a bit further in a white paper that compared the performance of sectors, high- and low-yielding stocks and the S&P 500 under various dividend and capital gains tax rates. They found that high-yield stocks have outperformed the S&P and non-dividend paying stocks over most time periods, including when taxes on dividends were considerably higher than levies on capital gains.

Dividend-paying stocks did outperform in the years following the enactment of the cuts in 2003. But thats more likely the result of retired investors increasing dependence on investment income, as well as the lack of consistent growth opportunities in the stock market.

Neither of these factors is likely to go away any time soon. Moreover, even if dividends are taxed as ordinary income, they wont be docked any more than bonds are now. And unlike fixed income, dividends can be raised, so long as theyre backed by strong businesses.

A higher tax on dividend income would make master limited partnerships (MLP) considerably more attractive to high-income investors. And in light of the recent selloff in MLPs, nows a good time to buy the best of them. MLPs pay a large portion of their distributions as return of capital (ROC), so investors are not taxed on them until they sell. And assuming investors hold the MLP for at least a year, the fact that ROC is deducted from an investors cost basis means that its effectively taxed at the long-term capital gains rate once the MLP is sold.

Its possible a post-election Washington budget compromise could include a new tax on MLPs. That risk was addressed during the MLP Investor Conference I attended this week in Greenwich, Conn. with my MLP Profits co-editor Elliott Gue. Arguing against it, however, is the fact that MLPs are still a small corner of the investment universe, with the 50 largest still trading with a lower market capitalization than ExxonMobil (NYSE: XOM). MLPs also have many friends in Congress on both sides of the aisle, and even full taxation would net the US Treasury just $1.6 billion.

I strongly advise every investor to take at least a small stake in selected energy midstream MLPs, mainly because theyre the most reliable way to cash in on the rapid growth of energy production from US shale reserves. But just as other dividend-paying stocks didnt rally in the wake of the 2003 passage of the Bush tax cuts, neither will they fall if tax rates adjust upward again.

That means no Taxmageddon. Despite the likelihood of higher dividend taxes next year, companies that share the wealth with their investors via dividends will remain the stock markets surest road to wealth building.

What is important is how individual companies are holding up to the pressures of the current economy, including both the volatile markets and the sharp drop in natural gas prices over the past six to nine months. But so long as underlying businesses stay strong, dividend-paying stocks will recover whatever damage they suffer now as the result of fears over a potential Taxmageddon. Thats why investors need to stay focused as we approach what appears to be an especially wild election season.