On Christmas Eve 1945, in Bedford Falls, New York, George Bailey contemplates suicide. The prayers of his family and friends reach Heaven, where guardian angel second class Clarence Odbody is assigned to save George in order to earn his wings. Clarence is shown flashbacks of George's life. He watches 12-year-old George rescue his younger brother Harry from drowning, but become deaf in his left ear. Later, George prevents the pharmacist, Mr. Gower, distraught over the death of his son, from accidentally poisoning a prescription.

In 1928, George plans a world tour before college. He is reintroduced to Mary Hatch, who has been enamored with him since childhood. When his father dies suddenly, George postpones his travel to settle the family business, Bailey Brothers Building and Loan. Avaricious board member Henry F. Potter, who controls most of the town, seeks to dissolve it, but the board votes to keep the Building and Loan open if George runs it. George acquiesces and works alongside his uncle, Billy, and gives his tuition to Harry with the understanding that Harry will run the business when he graduates.

Harry returns from college married and with a job offer from his father-in-law, and George resigns himself to running the Building and Loan. George and Mary rekindle their relationship and are married. They witness a run on the bank and use their honeymoon savings to keep the Building and Loan solvent. Under George's leadership, the company establishes Bailey Park, a modern housing development surpassing Potter's overpriced slums. Potter entices George with a job for $20,000 a year but, realizing that Potter's true intention is to close the Building and Loan, George rebuffs the offer.

During World War II, George is ineligible for service because of his deaf ear but is active in the domestic war effort. On Christmas Eve 1945, the town prepares a hero's welcome for Harry, who was awarded the Medal of Honor for his actions as a U.S. Navy fighter pilot preventing a kamikaze attack on a troop transport. Billy goes to Potter's bank to deposit $8,000 of the Building and Loan's cash. He taunts Potter with a newspaper headline about Harry, but absentmindedly wraps the envelope of cash in Potter's newspaper. Potter finds the money and keeps it, while Billy cannot recall how he misplaced it. With a bank examiner reviewing the company's records, George realizes scandal and criminal charges will follow. Fruitlessly retracing Billy's steps, George berates him and takes out his frustration on Mary and their kids. George appeals to Potter for a loan, offering his life insurance policy as collateral. Potter chastises George, refuses to help, and phones the police.

George flees Potter's office, gets drunk at a bar, and prays for help. Suicidal, he goes to a nearby bridge, but before he can jump, Clarence dives into the river and George rescues him. When George wishes he had never been born, Clarence shows George a timeline in which he never existed. Bedford Falls is now Pottersville, an unsavory town occupied by sleazy entertainment venues, crime, and callous people. Mr. Gower was imprisoned for manslaughter because George was not there to stop him from accidentally poisoning the prescription. George's mother does not know him. Uncle Billy was institutionalized after the Building and Loan failed.