Studies in amphibian embryos have suggested that retinoic acid (RA) may function as a signal that stimulates posterior differentiation of the nervous system as postulated by the activation-transformation model for anteroposterior patterning of the nervous system. We have tested this hypothesis in retinaldehyde dehydrogenase-2 (Raldh2) null mutant mice lacking RA synthesis in the somitic mesoderm. Raldh2(-/-) embryos exhibited neural induction (activation) as evidenced by expression of Sox1 and Sox2 along the neural plate, but differentiation of spinal cord neuroectodermal progenitor cells (posterior transformation) did not occur as demonstrated by a loss of Pax6 and Olig2 expression along the posterior neural plate. Spinal cord differentiation in Raldh2(-/-) embryos was rescued by maternal RA administration, and during the rescue RA was found to act directly in the neuroectoderm but not the somitic mesoderm. RA generated by Raldh2 in the somitic mesoderm was found to normally travel as a signal throughout the mesoderm and neuroectoderm of the trunk and into tailbud neuroectoderm, but not into tailbud mesoderm. Raldh2(-/-) embryos also exhibited increased Fgf8 expression in the tailbud, and decreased cell proliferation in tailbud neuroectoderm. Our findings demonstrate that RA synthesized in the somitic mesoderm is necessary for posterior neural transformation in the mouse and that Raldh2 provides the only source of RA for posterior development. An important concept to emerge from our studies is that the somitic mesodermal RA signal acts in the neuroectoderm but not mesoderm to generate a spinal cord fate.