Retainage is the practice of temporarily withholding payment from a contractor for work performed. Project owners use retainage to mitigate risk by setting aside a portion of payments (5-10%) should the contractor default or fail to meet contractual obligations.
While highly divisive, retainage remains a construction industry standard. You must be diligent with your contracts, become familiar with state laws, plan for cash flow needs, and consider financing options to better confront the impacts of retainage. In this article, we’ll discuss everything you need to handle your next retainage contract with confidence.
What does retainage mean in construction?
Retainage had its genesis in the 1840s in the UK when the country was taking on the immense task of building a massive new railroad system. No one had ever tried such a project before; resulting in an unprecedented demand for labor. Looking to fill this demand, project owners had no choice but to bring on large amounts of inexperienced workers and contractors. As a result, many projects failed to meet expectations or weren’t finished at all.
In an attempt to remedy poor performance, project owners came up with the practice of retainage–withholding a portion of what is owed to a contractor for work performed until the contract is complete. Project owners did this to ensure that full payment was only released upon completion of quality work.
At first, retainage amounts were as high as 20% and project owners used it to offset completion costs in case the contractor fell into default. Today, retainage rates typically fall between 5-10%. But the conditions still largely remain the same as they did in the 1840s: if the work performed isn’t of sufficient quality or doesn’t match the scope of work, the project owner is within their right to withhold a portion of funds from any final payments.
In an industry with tight margins and constant cash flow struggles, a 5-10% reduction in revenue can spell real financial trouble. You’ll have to answer some difficult questions: how should we factor retainage into our budget for this job or the next one? When will I get paid the full amount, and how will it disrupt our timelines? Will retainage cause cashflow issues preventing me from bidding on new jobs?
Answering these questions isn’t easy, but we’ll help you get there. Next, we’ll take a more in-depth look at how retainage works and how to account for it on projects.
How retainage works in a construction project
Retainage works by removing a percentage of money from each payment owed to a contractor. For example, if you’re working under a $50,000 contract with a retainage percentage of 5%, the total amount retained will equal $2,500. However, retainage isn’t typically withheld all at once. Usually, the 5% in retainage will be withheld from each progress payment.
As a contractor, your critical task is ensuring that retainage is held back on each progress payment. If you choose to use payment applications than they must clearly reflect the correct retainage amount withheld.
Remember to take the full payment amount, less retainage. Most payment applications will include specific fields and guidelines to help you calculate payments with retainage included.
The American Institute of Architects (AIA) offers standardized pay app templates that provide convenient guidelines for getting these numbers right. For example, the G702 and G703 AIA-style documents include sections that prompt you to determine the actual amount that you receive minus retainage.
How is retainage calculated?
At a high level, you can calculate retainage by taking the agreed upon percentage out of each payment. For instance, let’s again take a $50,000 contract with 5% retainage. Let’s also assume the project calls for five payments. In this scenario, 5% ($500) will be withheld from each of the five progress payments.
| Progress Payment number | Payment before retainage | Retainage amount (5%) | Total payment less retainage |
|---|---|---|---|
| #1 | $10,000 | $500 | $9,500 |
| #2 | $10,000 | $500 | $9,500 |
| #3 | $10,000 | $500 | $9,500 |
| #4 | $10,000 | $500 | $9,500 |
| #5 | $10,000 | $500 | $9,500 |
| Total | $50,000 | $2,500 | $47,500 |
How you reconcile payment and revenue will depend on the terms of your contract. This is because retainage percentages can be fixed (remaining unchanged throughout the job) or variable (sequentially declining in size or even eliminated once the job hits substantial completion or specific milestones).
For fixed-rate agreements, the same retainage percentage is applied to the entire contract price and divided by the number of progress payments (exactly like our example above). The formulas for this example are as follows:
Total retainage amount:
$50,000 * .05 = $2,500
Retainage withheld from each progress payment
$2,500 / 5 payments = $500
When it’s time to prepare an invoice, you’ll calculate the full progress payment amount and deduct the retainage amount on the next line. It’s then the project owner’s responsibility to deduct the retainage percentage and hold it in a separate account unless state requirements dictate otherwise.
How long is retainage held?
How long retainage is held and subsequently paid back depends on three things:
- The details of the contract
- Negotiated terms
- Location
Traditionally, owners will hold retainage until the contract has been fully executed. A satisfied contract, however, doesn’t mean retained money will hit your bank account as soon as the project ends. Project owners must confirm that no rework is needed, punch-list items must be finalized, and owners must make good on their promise of timely payments. From there, the payment chain takes its course–owners issue payments to GCs, who then issue payments to their subcontractors and so forth.
What this means is that general contractors may have to wait a couple of months for full payment, while subcontractors may have to wait up to 5-months or longer. You’ll wait even longer if your portion of the job was completed in an earlier stage of the project. Don’t be surprised if you see the ball drop on NYE before you see your retainage money. Unfortunately, it’s also possible that you never receive full payment at all. One way to safeguard yourself from this risk is to take the time to understand your local and state laws pertaining to retainage.
It’s also common to see construction contracts call out “substantial completion” as the trigger for repayment. However, “substantially complete” leaves a lot of room for interpretation. Before you sign any contracts, be sure to have a clear definition (in writing) of what substantially complete means for this specific project. It’s vital that you, your GCs, and the project owner are all on the same page here. We also recommend you consult with a legal representative as part of this process to ensure you are properly protected.
Familiarize yourself with federal and state laws on retainage
The U.S Department of Labor and the Fair Labor Standards Act make it clear that contractors and project owners must comply with their state’s retainage laws. However, retainage laws vary from state to state with contrasting sets of requirements. On the federal level, there are no laws that govern retainage on private sector projects/jobs. It’s up to each state to decide. However, there are federal regulations concerning public sector construction projects. Retention at the federal level is typically capped at 10% with the following explanation:
“…the Contracting Officer shall authorize payment to be made in full. However, if satisfactory progress has not been made, the Contracting Officer may retain a maximum of 10 percent of the amount of the payment until satisfactory progress is achieved.”
At the state level, things get more interesting. In California, for instance, retainage is capped at 5% in the public sector, and a contractor may substitute securities instead of retainage payments or request that payments be made into an escrow account. For private projects, retainage must be released within 45 days of the “date of completion.”
In contrast, Texas declares no such cap on retainage percentages for public projects. Meaning there’s no maximum rate of retainage. Instead, they declare that any contract with a retainage amount that’s 5% and under $400,000 in contract value must have retainage funds deposited in an interest-bearing account which will be repaid (with interest included) to the contractor upon project completion. In the private sector, for any work that’s eligible for a mechanic’s lien, the project owner is required by law to retain 10% of either the contract price or the value of the work completed.
Even more stark, New Mexico prohibits retainage entirely for both private and public projects. But contractors in New Mexico should be aware that they still encounter retainage, albeit in a different form. For example, contracts will include a line item in the schedule of values that allocates funds for “close out.” The amount of funds directed toward this “close out” line item amount to 5-10% of the total contract value. In effect, this functions in the same way as traditional retainage, as money is being held back from those who have earned it.
As you can see, retainage laws vary significantly from state to state. For this reason, it’s crucial to learn your state’s retainage laws by heart. If you need help getting started, check your local department of labor, talk to your counsel, speak with fellow contractors within your trade, and reach out to your local contractor association.
The impact of retainage on construction accounting
How does retainage impact a contractor’s cash flow?
The impacts of retainage on cash flow:
- Reduces payment totals limiting cash flow
- Can immediately require you to operate with a negative cash flow
- May require contractors to find other means to meet cash needs
Simply put, retainage reduces the amount of cash coming in on each payment limiting the amount of working capital you have to purchase materials, schedule full crews, and cover various costs. Failing to account for retainage can complicate your cash flow strategy or leave you strapped for cash in later project phases.
You can’t budget jobs based on the face value of payments. You must budget around the amount you’ll receive less retainage. For example, a $10,000 payment at 10% retainage will result in a $1,000 gap. The $1,000 withheld from this payment can be easily more than enough to cause serious cash flow issues, production delays, missed payroll, scheduling issues, or disruptions in material deliveries. Especially when we factor in the potentially long lead times to receive payment. For this reason, you must keep retainage front of mind when budgeting. In certain situations, you may need to seek financing options to meet your cash needs. Better to identify and plan for this ahead of time rather than halfway through a job.
Moreover, if profit margins are tight, which they often are, then retainage amounts can be greater than the negotiated bid percentage of profit. For example, if you win a construction contract and expect to have a profit margin of 8%, but the contract withholds 10% in retainage, you’ll find yourself in negative cash flow and in the red by 2% from the get-go.
The benefits and drawbacks of construction retainage
In the volatile labor market of the 1800’s, retainage was a logical protection plan. Project owners needed to ensure quality work before shelling out more cash. 180 years later, many project owners still feel the same sentiment. If you’re an honest and hard-working contractor, though, this can all seem quite unfair.
Why should you have to wait on full compensation when you know that you’ll deliver quality work? Why should you have money withheld when the project owner trusted you enough to award the contract? Why should a few bad contractors ruin it for the rest of us?
These are all valid questions. The truth is that retainage has remained a legacy practice of a construction era long forgotten. Whether you agree with it or not, it’s not going anywhere any time soon, which means contractors must understand its benefits and drawbacks so they are better prepared to encounter it.
Benefits of Retainage in Construction:
- Mitigates risk for project owners
- Incentivizes contractors to finish projects quickly and correctly
- Provides an extra layer of assurance for project owners who face inadequate outputs
Drawbacks of Retainage in Construction:
- Reduces payment amounts for contractors
- Can require contractors to operate with a negative cash flow and generate other cash flow issues
- May come with long lead times to receive payment
- May require contractors to seek financing options to meet cash needs
- May result in disputes as a result of payment terms or “substantial completion” details
- Has the potential for abuse from project owners
Strategies for minimizing the impact of retainage
Read the fine print
Understand the specific rate, details for repayment, and all relevant provisions in your contract: Is this a variable retainage rate? Fixed-rate? Does it depend on substantial completion? These are the questions you need to be able to answer with extreme confidence.
Contracts are notorious for complicated language, so never shy away from consulting with a legal representative if you need additional clarification, guidance, or advice.
Negotiate
Always aim to have a full understanding of the contract, and don’t feel obligated to accept the terms as they are. Negotiate if you feel that the retainage percentage and terms are going to cause a cash crunch or make day-to-day operations difficult.
If something isn’t made clear, don’t wait to bring up retainage questions after the fact. It’s crucial to address any issues you have upfront. Have these discussions early and often before you sign and finalize the paperwork.
In these discussions, iron out payment timelines and unique details like earning interest. Try to negotiate a lower percentage and shortened timeframes if you can. Or advocate for a variable retention rate that eliminates retainage at an agreed-upon milestone, such as 50% complete. Finally, stay diligent and transparent. If you know retainage terms will cause you to run into cash flow issues, bring it up. If timelines don’t work for your crew, bring it up.
Understand state laws
State laws have a significant impact on how retainage is structured and applied to contracts. You must know how your state handles retainage and be on the lookout for any unique requirements. Remember that in Texas, owners must hold retainage funds in an interest account. This kind of information can be invaluable in the event that funds are mishandled.
In a worst-case scenario, you may need to enact your lien rights. This should only be done when all other options have been exhausted. If you do go this route, you’ll need to make sure you do your homework and have plenty of supporting documentation and evidence to support your lien actions. As always, consult with a lawyer before signing contracts or enacting your lien rights. Never make these decisions on your own. When in doubt, seek legal advice.
Work with an accountant
As a business owner, you can’t do it all on your own. Payment apps, tax considerations, and cash flow management can all become overwhelming. If you’re unsure of what to do next, find a CPA or accounting professional with construction accounting experience that can help point you in the right direction.
If you have an in-house accountant, consider creating a contingency or emergency fund. This reserve of cash can be used to help supplement cash shortages created by retainage. In the unfortunate event that you never receive your retainage payments, this fund can be a lifesaver, helping you bear the brunt of lost income without it wreaking havoc on your operations.
Factor it into your cash flow needs
Your best bet is to plan and budget around retainage. If you’re relying on retainage funds to hit your account in order to procure materials or hit payroll, you need to take a step back and rethink how you are budgeting for retainage contracts. Consider withheld funds as sunk costs as you’re budgeting and bidding. Try to anticipate gaps in cash ahead of time. This way, you can reallocate funds or schedule in a more labor-efficient manner. You can also look into and instigate financing options early so you can secure cash for job phases where you need it most.
You can also look into subcontractor performance bonds or retainage bonds as a unique alternative to traditional retainage. Subcontractor performance bonds are a special agreement between a subcontractor and a surety. In this agreement, the surety guarantees to complete the project in place of a subcontractor should the subcontractor fail to meet contractual obligations.
In a retainage bond, an agreement is made where instead of withholding a percentage of progress payments, the surety will pay up to the amount that would have been retained in the event that the contractor fails to perform. With a retainage bond, the project owner has an insurance plan against poor performance, and contractors can avoid the financial harm of withheld funds.
Use software
Having competent accounting software in your business toolkit can significantly improve how you handle retainage contracts. With tools like Knowify, you can confidently track expenses, documents, job phases, and more to ensure everything is accurate and organized. The best part is that Knowify supports retainage specifically, particularly with its AIA-style invoicing (payment application) feature set.
Knowify will let you change your retainage amount part-way through a job and will correctly adjust your next pay app for you. This feature is particularly handy if you negotiate a reduction in retained funds toward the end of the project.
Stay organized, on budget, and efficient through Knowify’s all-in-one solution built specifically for contractors. Book a 30-minute demo today and see for yourself!