The residual presence of integrated transgenes following the derivation of induced pluripotent stem (iPS) cells is highly undesirable. Here we demonstrate efficient derivation of iPS cells free of exogenous reprogramming transgenes using an excisable polycistronic lentiviral vector. A novel version of this vector containing a reporter fluorochrome allows direct visualization of vector excision in living iPS cells in real time. We find that removal of the reprogramming vector markedly improves the developmental potential of iPS cells and significantly augments their capacity to undergo directed differentiation in vitro. We further propose that methods to efficiently excise reprogramming transgenes with minimal culture passaging, such as those demonstrated here, are critical since we find that iPS cells may acquire chromosomal abnormalities, such as trisomy of chromosome 8, similar to embryonic stem cells after expansion in culture. Our findings illustrate an efficient method for the generation of transgene-free iPS cells and emphasize the potential beneficial effects that may result from elimination of integrated reprogramming factors. In addition, our results underscore the consequences of long-term culture that will need to be taken into account for the clinical application of iPS cells.