Managing Retainage and Its Impact on Construction Tax Liabilities
- Cost Construction Accounting
- May 26
- 5 min read
As a construction bookkeeping professional, one of the most misunderstood areas I’ve seen among contractors is managing retainage—and more importantly, how it affects construction tax liabilities. If you've ever felt unsure about when to report retainage as income, or how it affects your tax planning, you're not alone.
In this article, we’ll break down what retainage really is, how it impacts your books, and how to stay compliant with tax regulations—all in a language that’s clear and useful for everyday construction business owners.
What Is Retainage in Construction?
Retainage, also known as retainage in construction, refers to the portion of a contractor’s payment that is withheld by the project owner or general contractor until a project is completed or certain milestones are met. Typically, it ranges from 5% to 10% of the contract value.
This practice helps ensure that contractors finish the job properly and that any issues post-completion are resolved. While it sounds reasonable from a project owner’s point of view, it can be a real challenge for your cash flow and tax planning.
Why Should Contractors Worry About Retainage?
As a contractor, retainage affects more than your revenue stream—it affects how and when you report income, and ultimately, how much tax you owe. If construction retainage is not handled properly in your books, you might:
Overstate your income
Pay taxes on money you haven’t received yet
Face issues during audits
Knowing how to manage retainage can help you avoid these pitfalls.
How Retainage Affects Construction Tax Liabilities
One of the most common and important questions contractors ask is:
“When do I have to pay taxes on retainage?”
The answer depends entirely on your company’s accounting method—whether you use the cash basis or the accrual basis of accounting.
Tax Treatment of Retainage by Accounting Method
Accounting Method | When Retainage is Taxed |
Cash Basis | When the retainage is actually received—only after the client pays |
Accrual Basis | When the retainage is earned—typically when the invoice is issued or the work is completed |
The cash basis is used by most small to medium-sized building companies. This can help them with their taxes. With this method, you don't have to pay taxes on retainage until the money is in your account, since you don't have to report income until you get it.
If your business uses the accrual method, on the other hand, you have to report retainage as income as soon as it's made, even if you don't get the money for a few months. This can make you owe money in taxes before you get the money, which could cause cash flow problems if you don't handle it right.
Best Practices for Managing Retainage
Retainer management isn't just about staying organized; it's also about staying in compliance, making the most of cash flow, and lowering tax risk. For correct and useful retainage accounting, here are some best practices:
1. Separate Retainage from Regular Accounts Receivable
You shouldn't put retainage in the same account as your other accounts due. Instead, you should keep it separate. This makes it easy to tell the difference between funds that are owed right now and those that are waiting for certain tasks to be completed or approvals to be given.
By separating retainage:
You avoid overstating current receivables.
You can generate clearer reports for financial forecasting.
You gain visibility into how much retainage is outstanding across all projects.
Pro tip: Use accounting software like QuickBooks, Sage 100 Contractor, or Viewpoint with a built-in retainage tracking system to automate this process and reduce manual errors.
2. Use Itemized and Clear Invoicing
You should clearly show retainage as a different line item on every invoice you send. This way, your client will know exactly how much is being held back and why. This will help avoid problems or confusion in the future.
A typical invoice format might look like this:
Description of Work | Amount | Retainage (10%) | Amount Due |
Rough Carpentry Labor | $50,000 | $5,000 | $45,000 |
Benefits of clear invoicing include:
Improved client communication
Easier audits and reconciliations
Stronger documentation in the event of payment disputes
3. Monitor Retainage Deadlines and Collection Periods
A lot of the time, retainage is due when the job is finished, but many contractors forget to follow up, which costs them tens of thousands of dollars.
Set up a way to keep track of things or a calendar alert to remember you to follow up once the conditions for releasing the retainage have been met. For example, complete the items on the punch list, submit lien waivers, or wait a certain amount of time after the job is finished.
You can also:
Assign retainage follow-up as a task within your project management workflow.
Review retainage balances monthly to ensure nothing is slipping through the cracks.
Include retainage aging reports in your regular financial review process.
Did you know? Some retainage agreements include specific timeframes for release (e.g., 30 days post-completion). Missing these deadlines can result in delayed payments or even forfeiture if your claim isn’t submitted properly.
Tax Planning Tips for Retainage
Properly handling retainage withholding is just one part of tax planning for contractors. Here are some additional strategies:
Work with a construction-savvy CPA: Not all accountants understand the nuances of construction accounting.
Review retainage schedules at year-end: Ensure you're not reporting income too early.
Create a retainage forecast: Knowing how much retainage you’ll collect (and when) helps with cash flow planning and quarterly tax estimates.
How to Stay Compliant with Construction Tax Laws
The IRS doesn’t offer special rules just for the construction industry. That means it’s up to you to be proactive in:
Classifying retainage correctly
Keeping thorough records
Separating retainage from regular revenue
Your bookkeeper or accountant should ensure retainage is included in contractor tax strategies to reduce risk and improve compliance.
How to Track Retainage on Your Own
If you’re a hands-on contractor or have a small team, here’s how to track retainage manually:
Create a separate GL account in your accounting software called “Retainage Receivable.”
Deduct retainage as a line item on every invoice.
Log the withheld amount in the retainage account and adjust it when payment is received.
Review retainage balances monthly and set reminders for follow-ups.
If using Excel or Google Sheets, build a tracker with these columns:
Project Name
Customer
Invoice Date
Total Amount
Retainage %
Retainage Amount
Payment Status
Retainage Due Date
When to Consider Professional Help
If you're struggling to manage this process, you're not alone. Many contractors spend hours reconciling retainage each month—often with missed entries or outdated spreadsheets.
Once your project volume grows or tax planning becomes more complex, it may be time to bring in outside help.
That’s where our team at Construction Cost Accounting can help. We specialize in construction bookkeeping services, including retainage tracking, tax reporting, and cash flow optimization.
Our role isn’t just to take over your books—it’s to give you clarity, confidence, and control. If you're already doing the hard work of building projects, let us help you build a better financial system that supports your success.
Conclusion
Retainage isn’t just a minor withholding—it can impact your tax bill, your cash flow, and even your business’s growth. By understanding how it works, applying best practices, and choosing the right accounting support, you can stay ahead of the game.
If you’re ready to tighten up your processes or finally get retainage under control, now is the time.
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