A Guide to Retainage in Construction (2024)

One of the distinctive aspects of the construction industry is that for many projects,contractors know going in that they aren’t getting paid in full until the work iscompleted.Welcome to the practice called retainage, which allows a project owner to hold off on payingthe full price until the project is “substantially complete” and signed off on.To ensurethey’re ultimately paid all monies held back, construction contractors need a thoroughunderstanding of the details of retainage, why it exists, how it affects owners,contractors, subcontractors and suppliers, and the ways its impact can be managed.

What Is Retainage?

Retainage is the withholding of a portion of the final payment for a defined period to assurea contractor or subcontractor has finished a construction project completely and correctly.Retainage, a standard practice in both public and private projects, functions as a financialincentive and guarantees that the project is completed to the owner’s satisfaction.Theamount held back is typically defined in the contract, and usually ranges between 5% and 10%but can sometimes be higher.

Retainage vs. retention: What’s the difference?

These two terms are often used interchangeably, but in certain cases the terms retainage andretention have different meanings. In construction, retainage may refer to the amount beingheld back, and retention could indicate the act of withholding the money.

Key Takeaways

• Retainage percentages and payment structures are set forth in construction contracts andcan change by project.
• Retainage often limits a contractor and subcontractor’s cash flow and may lead toabusive financial tactics.
• Government regulations on retainage vary by state and whether a project is public orprivate.
• Other options such as bonds or separate security can be used as well, but retainagestill remains one of the most effective ways to ensure a job is correctly completed.
• Financial management software can help businesses better manage their retainagereceivables and payables.

Retainage Explained

The idea behind retainage is to create financial incentive for contractors to complete theproject and offer protection for owners should problems arise during construction or for aspecified amount of time after completion. Also, since profit margins in construction oftenare low, the standard retainage of 5% to 10% usually winds up being the contractor’sprofit.Thus, retainage encourages timely and appropriate completion.

Details of retainage must be spelled out in the contract between owner and contractor, aswell as between the contractor and subcontractors. States vary in their regulations ofretainage. Some states are specific, some are vague and some have no regulations at all.It’s important to determine the specific rules in the states where a contractor works.

If retainage details are not spelled out specifically in a contract, then there is noretainage.

How Does Retainage Work?

The payment schedule and the percentage of money to be withheld is detailed in the contractbetween parties. Typically, that retainage amount is taken out of each progress payment. Forexample, if a project calls for 10 payments of $20,000 each and a 10% retainage wasnegotiated, then the owner would pay $18,000 each time. The remaining $20,000 in retainagegets released upon completion of the construction project or a specified period aftercompletion, depending on the terms of the contract.

Retainage from individual installments may not necessarily represent much hardship during theconstruction process. But over the course of the project, that money adds up to a strongincentive for a contractor to finish the job. When the retainage terms are met, the money isreleased and paid to the contractor, who then must pay withheld money to subcontractors.

Sometimes, retainage may be determined based on the stage of the project, where thepercentages vary depending on construction benchmarks. The details and percentage ofretainage can vary from job to job and from state to state for public projects.

State regulations governing holding time of retainage vary for both public and private jobs.For example, in California, retainage on private projects must be released within 45 days of“date of completion.” The contractor then has 10 days to pay retainage tosubcontractors. InNew York, retainage must be released within 30 days after “final approval of thework,” withsubcontractors needing to receive their withheld funds within seven days.

Note the two states’ selection of words, which indicate two different concepts: date ofcompletion versus buyer approval. It’s not uncommon for opinions to differ on whatconstitutes completion of a job.

Why Is Retainage Important?

Retainage is meant to encourage productivity and efficiency. It provides financial incentivefor a contractor to finish the job and do it well. Many consider it the most effectiveinsurance policy an owner has over contractors, and contractors over subcontractors andsuppliers.

Retainage may be most important in the last stages of a project. If a contractor were to havereceived all progress payments in full, that contractor may decide it’s a better playfinancially to move on to the next project should problems or a dispute with the projectowner arise. For the owner, retainage provides funds should a contractor or subcontractordefault on the job. If a contractor can’t complete the work agreed on for any reason(e.g.,lawsuit, fraud or frozen assets), the funds held in retainage can be used to paysubcontractors or another contractor to finish the job.

But for contractors, retainage can lead to cash flow concerns. As they wait to receive theirfull fees for one project, they still must pay their employees their full wages, makeinsurance payments, buy supplies and equipment and finance new projects. Overcoming cashflow concerns can be a major hurdle, especially for small businesses. And tight cash flowcan lead to tensions in business relationships and dealings.

History of Retainage

Retainage began in the United Kingdom in the 1840s during the boom in railroad constructionoften referred to as “railway mania.” As the speculation bubble of railroadinvestment grewacross the U.K., so too did construction and the creation of new companies, each competingin a largely new and unregulated industrial sector. This elevated the demand for contractorsin the mid-19th century labor market. Many of the people who filled the void lackednecessary experience, qualifications and skill sets to complete their jobs properly. Suchsubpar craftsmanship forced railroad companies to begin withholding as much as 20% of thepayments due contractors to ensure work was done properly and effectively.

If they leave without warning, having to unexpectedly replace contractors and other workerswas time-consuming and expensive. Retainage helped guard against those costs. Retainagesought to hold back the profit portion of the money for the contractor, rather than put theinvestor’s money at risk, thereby incentivizing proper execution of the project.

Purpose of Retainage

Retainage, also referred to as a “hold back,” helps the owner ensure a contractorsufficiently completes the project, and that the work meets with their approval and terms ofthe contract. It also provides a financial incentive for the contractor to see the projectthrough to its successful finish. Withheld funds act as a safeguard for everyone involved inthe project, from the owner on down through subcontractors and suppliers.

What Are the Rules of Retainage?

The agreed-on terms of a construction contract dictate the specifics of retainage, such aspercentage withheld, how much is withheld with each payment and when the funds can bereleased. Keep in mind, most states have set some legal limitations. Those limits may differif it is a federal project, a state or county project or a private project. It’s besttoknow the specific retainage rules of the state you will be working in before signing thecontract.

On federal projects, as much as 10% can be held back by the project owner “untilsatisfactoryprogress is achieved,” according to the Federal Acquisition Regulation. In practice,though,it often scales lower and includes gradual reduction as construction benchmarks are reached.A contractor also may use retainage with subcontractors, even if the government is not doingso with them. However, in these cases, that contractor can’t bill the government forthewithheld money. This, in effect, creates an unofficial retainage by the government.

When it comes to state, county and municipal projects, some states actually require retainagewhile others set limitations. In some states, withheld funds are defined as a percentage ofthe total contract price, not of each payment. So, depending on how the payment plan isstructured, a project could reach the maximum retainage amount early and then not have anyother funds held back in the final payments. There are states where the common practice isthat retainage ends after 50% project completion.

Some states cap retainage as 5% on public projects, whereas others use 10%. Retainagelimitations on private projects would vary by state.

Who Should Use Retainage?

Many in the construction industry may not want to use retainage, yet it remains one of thebest way to secure substantial completion of a project and protect the owner in case acontractor defaults on the job. That’s why project owners typically use retainage,especially for large projects. It’s an extra level of insurance for them. Contractorswhohave money withheld by the project owner should also use retainage with their subcontractorsto mirror the protection that the owner has established. Passing retainage down the linehelps contractors better manage cash flow and incentivizes subcontractors to complete theirportions of the job. Other best practices for construction accounting can help contractorsand subcontractors reduce the burden of held back funds.

Who Benefits From Retainage & How?

Retainage affects the entire construction chain. And while the notion of withholding moneymay seem unfair, the process of retainage does offer benefits, even for contractors andothers involved in the project.

1. Owners: The project owner benefits by an incentive for contractors tocomplete the job properly. An owner also can use withheld money to complete the job if acontractor defaults. Another way the owner can potentially benefit is by earninginterest on the retainage, depending on the terms of the contract.
2. Contractors: Similar to an owner, contractors also benefit by havingleverage over the subcontractors to complete their parts of the job. Contractors alsocould earn interest on subcontractors’ retainage if the contract allows for it.
3. Subcontractors: Subcontractors benefit indirectly by feelingincentivized to do the job completely and properly. Plus, if a contractor fails to meettheir obligations, subcontractors can receive their retainage from the owner.
4. Banks and insurance companies: Retainage on a project offers theseentities more security in the job getting done correctly and within budget, loweringtheir risks in lending or insuring the project.

Impact of Retainage on Contractors, Subcontractors and Material Suppliers

When a contractor begins a project with retainage attached, they know they’re notcollecting100% of the contracted amount right away. That makes an impact on how companies manage theirfinances and working relationships.

1. Contractors: With profit margins being low in construction, there canbe times when the retainage percentage is greater than the projected profit. Lengthydisputes about completion where there is any ambiguity can exacerbate those cash flowconcerns, and if the disagreement requires legal action, it can become an even morecostly burden for contractors. In such cases, a contractor may feel cash-strapped forthis and other projects, and sometimes compensate for it by withholding a higherpercentage on subcontractors. This can damage valuable relationships withsubcontractors, or even make it difficult to find workers willing to operate with such ahigh retainage percentage.
2. Subcontractors: Subcontractors often feel the biggest brunt ofretainage. For example, they may complete their portion of the work in the first month,then have to wait another 10 months for the entire project to finish beforethey’re paidin full. Meanwhile, in those 10 months, they still have to make 100% of their payrolland other costs of doing business on anywhere from 90% to 95% of earned revenue.
3. Material suppliers: They possess little to no leverage on the retainagefront. They may float all their costs at the outset and often have to wait the longestto receive full pay. The more hiccups in the construction project, the longer it takesfor suppliers to recoup owed money for supplies already purchased, delivered andinstalled.

Arguments Against Retainage

While retainage has its pros, it also has its share of controversy and negative feelings.After all, when you complete a job, you want to be properly and fully compensated in atimely fashion. Retainage can get in the way of that payment. And depending on when yourwork was done on the project, you may disproportionately feel those effects.

1. Retainage may exacerbate existing cash flow problems. Many constructionbusinesses often lay out the full costs and expenses of projects up front, then hope toget paid along the way. That puts them in a cash-flow bind. Adding retainage to thatonly tightens the vice.
2. It takes too long to collect. Even when getting paid on a regularschedule, the contractor still has to wait to be paid in full. The time frame forretainage release varies by state, and even then, there can be debate about whether ajob is completed to the satisfaction of the parties. This can have a worse effect on asubcontractor, particularly those who complete their work in the early stages of theproject and must wait until the entire job is done to collect.
3. It sows mistrust. Are contractors withholding funds from subcontractorsat a higher rate than what the owner is doing to them? If suspicion sets in,productivity and quality can suffer, which in turn can affect full release of moniesowed.

Calculating Retainage

Retainage may be fixed or variable, depending on the terms of the contract. With a fixedpercentage, typically in the 5% to 10% range, the same percentage of the total amount due isheld back from each payment. With variable retainage, the percentage can change based on thestage of project completion. For example, a 10% retainage could drop to 5% after a projectis considered halfway done.

The construction industry has an unusual payment process. Instead of sending an invoice,contractors use what’s called a payment application (aka pay application, anapplication forpayment or a pay app). These go beyond a simple invoice. They typically include progressreports of the completed work and materials delivered, subcontractor invoices, schedules ofwork still to be done, photos and payroll receipts, among other documents.

When retainage is held back in each progress payment, the contractor must account for it ineach pay app. This can be done by billing for the full amount of that payment, less theretainage and showing the new number in the final billing total.

For example, say you’re billing a client for a $20,000 initial payment on a $100,000job andthe contract calls for 10% retainage. Your payment application would show $100,000 as theoriginal contract amount, followed by a line indicating a payment due of $20,000. Then aline would deduct the retainage — in this example, $2,000 (10% of $20,000). The finaltotalfor this payment application is $18,000.

Each job may have its own set of unique requirements, making the process more complex. TheAmerican Institute of Architects (AIA) and the ConsensusDOCs group each offer standardizedpay app templates that can help boost your efficiency. And financial management software canhelp you track and manage these payments to make sure you’re not missing out onmuch-neededfunds.

Advantages and Disadvantages of Retainage

Where you land in the construction supply chain helps shape the pluses and minuses ofretainage. Here’s a look at the pros and cons.

Advantages:

• It works. Retainage has been practiced for more than 150 years for goodreason. It remains perhaps the most effective way to ensure satisfactory completion of aconstruction project.
• It offers financial incentive for quality work. All businesses want tobe properly compensated for their work. Withholding a few percentage points of theagreed-on price with each payment adds up over the course of a project, and is a way toensure work is done well and on time by contractors and subcontractors.
• It provides a built-in remedy. Should a contractor fail to complete aproject, the money held in retainage gives the owner a source of funding to paysubcontractors and suppliers to complete the work.

Disadvantages:

• It can cause financial hardships. Construction is a complex businesswith many different types of workers involved — including owners, contractors,subcontractors, sub-subcontractors, suppliers and labor workers. What subcontractors mayconsider completion of their projects, contractors may see as one part of the puzzle.And if the owner waits for the puzzle to be completed, retainage money is not paid out.And when it is paid, it goes to the contractor, who then pays subcontractors andsuppliers. In particular, this can more adversely affect a subcontractor whose work wasan early part of the project as opposed to those in the later stages.
• It can be abused. Construction contracts, as well as regulations insome states, specify how long the parties can hold on to the retainage funds. Some willhold onto it until the last possible day, simply because they can. In some instances,there may be disagreements of what constitutes a job well done. Some contractors holdback a greater percentage to subcontractors than what the owner withholds from them. Ifcontractors choose to not pass down retainage for subcontractors, the subcontractorshave to pay out of pocket, adding to their financial risk.

Four Steps to Eliminate Retainage

Retainage may be looked at by some as an outdated practice, yet it remains in place and isviewed by many as a necessary evil of the construction business. Still, there are ways topotentially eliminate it or at least mitigate its negative effects.

1. Use retention or surety bonds. In place of retainage, a constructioncontractor pays the premiums of a surety or retention bond. The customer of thatcontractor is the beneficiary. In a way, this acts like reverse retainage. But thedifference is that the contractor receives full payment along the way. The owner stillhas the opportunity to put in a claim against the retention bond if something with theproject goes awry. Ideally, you’d want the bond premium to be less than theretainagewould have been in order for this to make the most business sense.
2. Allow substitute security. An owner may allow a contractor to supplyanother form of security to help protect their investment, such as a bank letter ofcredit or a form of U.S.-guaranteed securities, such as bills, certificates or notes.
3. Set up a construction trust fund. Many states have enacted constructiontrust fund statutes. In this scenario, money received by a contractor for payment ofsubcontractors is held in an interest-bearing trust account. A contractor can’tusethose funds until everyone gets paid what they are owed. A contractor who uses thosefunds improperly can be held liable, and subcontractors have the right to sue for theirpayments.
4. Put retainage in an escrow account. By putting the withholdings fromprogress payments into an escrow account, a contractor could earn interest on it and usethat interest earned to pay down-the-chain expenses and retainage. It also could helpwith cash flow. These detailswould need to be spelled out in the contract.
5. Build a good reputation. It can’t hurt to ask, right? Ifcontractorshave solid reputations and a history of success, they can sometimes negotiate thepercentage down or ask for decreasing retainage percentages as the project passescertain milestones.

Statutes of Retainage

Every state has different regulations governing how owners and contractors can use retainage.Those statutes may cover the maximum percentage allowed, how funds are stored (aninterest-bearing escrow account, for example) and amount of time funds can be withheld.Within those parameters, there can be even more nuance within a state.

For example, in Illinois, private projects have a 10% maximum retainage amount, but it dropsto 5% when half of the project has been completed. But this doesn’t apply toresidentialprojects of 12 or fewer units.

No matter your role in the construction project, it’s worth being familiar with theregulations in your state. That includes the time frame for filing a mechanic’s lien,whichare documents you file so you can seek unpaid compensation. Often, the deadline for filingsuch a claim expires before retainage is due, and the laws on this are unclear in mostcases. Yes, you have the right to file a lien against a contractor or owner for withheldmoney, but that deadline could pass before the contractor or owner has any legal obligationto pay retainage.

Some states have started to address this. New York changed its lien laws to allow a claim tobe filed up to 90 days after retainage was due. Before that, it was up to 90 days aftercompletion of the work.

How Software Helps With Retainage

There’s no substitute for efficiency in business. And with the uniqueness of theconstructionindustry, contractors need management software that best optimizes their administrative andaccounting work. From digital invoicing to invoice approvals, and lien management to payingretainage, cloud-based financial management softwarecan help construction businesses of all sizes. It can automate invoicing, with specific lineitems for retainage in both directions (accounts receivable retainage and accounts payableretainage).

Financial management software also allows contractors to standardize their forms across allprojects, increasing efficiency. It helps pay subcontractors quicker as well, thus reducingerrors and risk. The more efficient you are with your accounting and paperwork, the more youcan dedicate company resources to the value-added and client-focused parts of the business.

Many in the construction industry consider retainage an unavoidable evil of doing business.But it remains an effective way to ensure a project is completed and done well. Owners oflarge projects consider retainage a key financial safeguard that lets them pay someone elseto finish the job in the event the initial contractor or a subcontractor defaults. Stateshave enacted regulations limiting retainage percentages and abuses, but those laws vary.It’s best to learn about the rules in the state or states where you do business. Andadvanced financial management software can help you navigate the nuances of retainage,including invoicing and managing complex retention structures.

Retainage FAQ

What does retainage mean in construction?

Retainage is the holding back of a certain amount of money paid to contractors andsubcontractors to ensure a project is completed and done well. This withholding typicallyranges from 5% to 10% of the full project cost. The project owner withholds retainage fromthe contractor, who in turn withholds it from subcontractors, who in turn withhold it fromsub-subcontractors and suppliers.

How is retainage calculated?

The agreed-on percentage of retainage is typically deducted from each progress payment.Certain states require the full retainage be withheld early in the project, either by aspecific payment number or by project completion milestones.

What is the difference between retention andretainage?

The terms “retention” and “retainage” mostly are usedinterchangeably. But in certaininstances, “retainage” refers to the money being held back and“retention” to the act ofwithholding the money.

What is retainage on an invoice?

The line items for retainage on an invoice show the amounts the project owner is supposed towithhold when paying the invoice. Different invoice line items may indicate how much moneyhas been withheld for various categories (labor, materials) and how much was paid out in aparticular progress payment.

Who holds retainage?

Who holds funds considered in retainage depends on the details of a construction contract.Retainage money can be held in an escrow account, a trust fund account or another separateaccount.

How long can a contractor hold retainage?

A contractor can hold back its retainage from subcontractors until the project is deemed“substantially complete” and the owner releases its retainage money to thecontractor. Eachstate regulates that time differently, so it pays to know the specific laws in your state.Subcontractors also have the right to file a mechanic’s lien to seek payments, but thedeadline for that might conflict with the retainage deadline, depending on eachstate’srules.

What is project retainage percentage?

A project’s retainage percentage typically is between 5% and 10%. Some states have setlimitations on how much can be withheld, and that can vary depending on whether it’s apublic project or a private project.

How is retainage recorded?

If a project that pays $250,000 has 10% retainage, for accounting purposes that means$225,000 is considered accounts receivable andthe remaining $25,000 is the retainage. Progress payments should indicate how much is beingwithheld each time. Good financial managementsoftware for projects will have line items to enter for retainage to helpconstruction businesses manage receivables and payables.