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There are many things to get worked up about as the midterm elections approach, but an imminent hike in dividend taxes isn’t one of them.

The handwringers warn that if Congress ultimately doesn’t extend the Bush tax cuts, which sunset at year-end, then top marginal rates on corporate dividends will jump to 39.6% from the current 15%. That would supposedly deal a body blow to the stock market and to the hopes and dreams of retirees and others who depend on income investing.

Well, I’ve got one word of advice for you: Relax. Taxes on dividends aren’t likely to go up that much. Even if they did, the top rate wouldn’t affect that many investors. Research shows the tax cut had little impact on most dividend-paying stocks when it was enacted, anyway.

And any emotional sell-off in dividend-paying stocks as a result of a tax hike is likely to be temporary. Because the simple fact is that for yield-hungry investors, dividend-paying stocks are the best, if not the only, game in town.

“This is not going to be a big deal. It doesn’t change the relative value of dividend-paying stocks,” says Josh Peters, equity income strategist and editor of Morningstar DividendInvestor. True, the dividend tax cut was clearly a boon to investors: It “saved equity investors $275 billion over the last eight years,” according to Howard Silverblatt of Standard & Poor’s—$141 billion on dividend taxes in S&P 500 stocks alone since 2003.

But a study done for the Federal Reserve showed it really didn’t boost companies’ dividend payouts much. “The ratio of dividend payouts to corporate earnings changed little after the tax cut,” wrote Jesse Edgerton, who observed “at most a modest role for the tax cut.”

Geungu Yu of Jackson State University also saw little impact on the prices of most stocks in the six months following the May 28, 2003 enactment of the legislation. The exception: the S&P Dividend Aristocrats, the 59 stocks in the S&P 500 that had had 25 consecutive years of increased dividend payments. There, the cut did significantly affect share performance, as investors valued the consistency of their dividend payments more at the lower tax rate.

So, what would a sudden rise in the dividend tax cut do? Probably not much, either, in the long run. First of all, the number of investors with a family income of more than $250,000 is small enough—2% of US households. How many retirees living off dividends and income investments make anything near that? And anyone who earns less will have their dividend payments taxed at lower marginal rates. “Most investors are not [hurt by] these tax increases,” says Peters. “It doesn’t affect REITs and MLPs, [for example].”

Real estate investment trusts were not covered by the 2003 tax cut, and their payouts are fully taxable. Yet those stocks surged in the 2003-2007 bull market as investors stuffed them into tax-advantaged retirement accounts. Many master limited partnerships pay out income that is not taxable, anyway, and investors have been flocking to them over the last year or so, while their prices have soared.

Also, what will actually happen in the lame-duck session of Congress that follows the midterm elections is still up in the air: All the Bush tax cuts may be extended, or the dividend tax rate may be raised a bit.

In fact, Roger Conrad, editor of Utility Forecaster and a leading expert on income-paying stocks, points out that “the Obama budget for 2011 already had a cap on the rate at 20% instead of 15%,” suggesting that was where the administration expected the rate to end up.

“Investor tax rates will be extended one way or the other. I expect 20% is probably the highest that you’ll see,” he says. (By 2013, another 3.8% would be added to that for new Medicare taxes.)

Investors’ big fear, he adds, is that if they’re not extended, there could be a sell-off, especially in dividend-paying stocks, by the end of the year. That, says Conrad, “would be a tremendous buying opportunity. There’s plenty of good news for dividends.”

Why? Because with interest rates so low, investors have had to take a lot more risk to find decent yields. They have poured more than $600 billion into bond funds since the end of 2008 and have piled into high-yield bonds. Bonds of longer maturities are vulnerable to sudden rises in interest rates, and high-yield bonds are particularly sensitive to a sharp decline in the economy, like a double-dip recession.

That makes stocks of solid, dividend-paying companies very attractive, as Jeremy Siegel of the Wharton School recently wrote in The Wall Street Journal. Also, the spreads between many dividend-paying stocks and most bonds are extremely favorable to investors. “I’d rather own a utility stock at 4.5% than a ten-year Treasury at 2.5%,” says Josh Peters.

He adds that with companies expected to pay out 25%-30% of earnings next year, that’s well short of the 50%-plus payout ratio they had until the mid-1990s, so there’s a lot of room for dividend increases in the years ahead.

Conrad likes Verizon (NYSE: VZ), the telecommunications giant. “It’s still yielding right around 6%. I think it’s about to enter a nice growth phase. It’s shed so much of its legacy business.” The company has been phasing out its dying landline business and focusing on FIOS, its multibillion-dollar initiative to provide fast Internet and high-definition video directly to homes. It also will finally be selling the Apple (NYSE: AAPL) iPhone to customers by early next year. “It’s come up quite a bit in the past few months,” says Conrad.” They’ve got a lot more up side.” The stock traded at around $33 Thursday.

Peters likes National Grid (NYSE: NGG), a UK-based company that owns several utilities in the northeastern US and also a national electric and gas transmission grid in Great Britain. He says it has a good combination of yield and growth—about a 6% dividend and annual growth of around 5% to 6%. It traded at around $45 Thursday.

His colleague Paul Justice, Morningstar’s director of North American ETF research, recommends the Vanguard Dividend Appreciation ETF (NYSEArca: VIG). It includes stocks of large, blue-chip US companies like Coca-Cola (NYSE: KO) and Procter & Gamble (NYSE: PG) that have raised their dividends for ten consecutive years.

It seems clear that the right dividend-paying stocks and ETFs offer a lot to investors in the coming years. So, don’t be deterred by the brouhaha about hikes in dividend taxes, the ultimate tempest in a teapot.

Disclosure: Author does not own any of the stocks or ETFs mentioned in this article.

Source: Don't Sweat a Dividend Tax Hike