Retainage is a common practice in construction that gives project owners assurance by incentivizing builders to fulfill their obligations. This is often invaluable, as only around 36% of homeowners report that they trust contractors to complete projects on time and on budget.
On the other hand, retainage in construction can create significant cash flow challenges for contractors and subcontractors. Here’s what you should know to manage it effectively, including how it works, why it exists and some ways to mitigate its impact on your finances.
What Is Retainage in Construction?
Retainage in construction is when a project owner withholds funds owed to a contractor until the completion of a certain milestone or milestones. Typically, the retainage amount is between 5% and 10% of each progress payment, and the release condition is substantial completion of the project.
In many cases, general contractors withhold a similar percentage from their payments to subcontractors, so the retainage effect trickles down the payment chain.
For example, imagine you submit a $100,000 invoice for the first chunk of work completed on a construction project, but your contract includes a 10% retainage clause. Your client pays you $90,000 and holds back $10,000.
You owe a subcontractor $40,000 for their share of the work, but you also withhold 10%, sending them $36,000 and holding on to $4,000.
Once you fulfill the condition for release—substantial completion of the project—the client transfers over the remaining $10,000, along with the retainage withheld from all subsequent progress payments. You use the funds to pay out your subcontractors.
Retainage vs. Retention
The term “retainage” is often used interchangeably with the term “retention” in construction. However, in some cases, you’ll see retainage being used to describe the funds being withheld and retention referring to the act of withholding.
Why Is Retainage Used?
Retainage is a longstanding tradition in the construction industry. It creates a financial incentive for contractors to finish projects on time and to the agreed-upon standards, including addressing any lingering punch-list items that might otherwise be neglected.
Without some form of leverage, project owners may struggle to ensure that construction companies finish the final details of a project to their satisfaction.
In addition, construction lenders often require retainage as a condition for providing financing. They want their own assurances that the project will be completed and that their funds will be used responsibly.
However, while retainage provides protection for project owners and lenders, it can be a significant detriment to contractor cash flows. As a result, many states have imposed regulations that restrict the practice to protect construction businesses, such as:
- Limiting maximum retainage percentages to 5% or 10%
- Mandating release of retainage upon substantial completion
- Requiring retainage to be kept in interest-bearing escrow accounts
For example, Texas requires that private project owners withhold 10% of a contract’s value for 30 days after project completion—no more, no less. This gives sufficient protection to owners and lenders while limiting the financial strain on contractors.
In this case, the retainage also doubles as protection for subcontractors, providing a reserve fund they can file a lien against if a contractor fails to pay them.
The Financial Impact of Retainage
Retainage can delay a construction business owner’s access to a substantial portion of each progress payment. In the meantime, you have to continue paying for labor, materials and other building costs, which can quickly result in cash flow issues.
As challenging as that can be for contractors, subcontractors often bear an even heavier financial burden. Because retainage trickles down the payment chain, they’re almost always subject to a longer wait than those above them.
Subcontractors also face an increased risk of nonpayment. Even when a project owner releases retainage, there’s no guarantee the receiving contractor will pass those funds along. They could become insolvent before ever having the opportunity.
This timing misalignment can be even more significant when subcontractors finish their work early in a project. In such cases, they might have to wait months or even years for the completion of the project before collecting their final payment.
Retainage Accounting
In addition to straining cash flow management, retainage creates an additional administrative burden. Depending on where you are in a construction project’s payment chain, you’ll have to track one or both of the following:
- Retainage receivable: These are the funds withheld from progress payments made to you by a project owner or contractor above you in the payment chain.
- Retainage payable: These are the funds you’ve withheld from progress payments to subcontractors below you in the payment chain.
Tracking retainage receivables and payables across multiple projects can be challenging, but automated boookkeeping software can help simplify the process, especially construction-focused solutions.
However, presenting these accounts on the financial statements in accordance with GAAP can be even more complex, as it involves an understanding of revenue recognition standards. Consider hiring a Certified Public Accountant to help you navigate the process.
How to Manage Retainage
Retainage on construction projects may be unavoidable sometimes, but that doesn’t mean you should simply accept its financial consequences. Here are some tactics you can use to help mitigate its impact on your business:
- Consider retainage bonds: A retainage or retention bond is a type of performance bond that can replace the need for an owner to withhold funds from progress payments. You may qualify to buy them from surety companies. If you fail to fulfill your obligations, the surety will cover costs up to the bond’s value.
- Negotiate retainage terms: You can often negotiate more favorable retainage terms as a contractor. For example, that might mean lowering the withholding percentage, shortening the timeline for release, or requiring the owner to keep retainage money in an interest-bearing escrow account.
- Factor retainage into forecasts: Retainage reduces your cash inflows from each progress payment, so make sure to include it in your projections. That will allow you to anticipate shortfalls more accurately and help ensure you have enough liquidity to meet your obligations throughout each project.
If you’re experiencing financial instability due to retainage, consider working with a fractional CFO. These professionals can provide expert support on demand, helping you navigate complex challenges like contract negotiations and cash flow forecasting.
FAQs About Retainage in Construction
How Does Retainage Work in Construction?
In construction, retainage involves a project owner withholding a percentage of each progress payment. Depending on state regulations, that percentage is typically between 5% and 10%, which incentivizes contractors to fulfill their obligations.
Upon reaching specific milestones—such as substantial completion of the project—project owners should release their retainage. In turn, contractors often use that money to pay whatever funds they withheld from their subcontractors.
What Is Retainage Payable and Retainage Receivable?
Retainage payable is the amount you’ve withheld from payments to subcontractors, while retainage receivable is the amount withheld from you by the project owner or a contractor higher up the payment chain.
How Long Can Retention Money Be Held For?
Retention money can be held for as long as the contract terms specify, up to state limits. Though regulations vary, many states require that project owners release retainage within a certain period, such as 30 or 60 days after substantial completion of the project.
Get Help With Construction Finances Through Paro
Retainage can be a significant hurdle for contractors. It erodes cash flows, complicates accounting, and pressures relationships both up and down the payment chain. It’s also one of many financial management challenges construction companies face due to their unique project timelines and payment structures. If you’d like help navigating retainage or some other financial complexity of the industry, explore Paro’s construction accounting and financial advisory services. We’ll connect you with experienced professionals who specialize in supporting businesses just like yours.
