In Bedford Falls, New York, on Christmas Eve, George Bailey is deeply troubled and suicidal. Prayers for his well-being from friends and family reach Heaven. Clarence Odbody, Angel 2nd Class, is assigned to save George. In order to prepare Clarance for his trip to Earth, his superior Joseph shows flashbacks of George's life.
In 1919, at age 12, George saves the life of his younger brother Harry, who has fallen through the ice on a frozen pond. Later, while working in the local pharmacy, George notices that the druggist has mistakenly filled a child's prescription with poison; George saves the druggist from inadvertently killing the child.
When George grows up he waits for Harry to graduate from high school and replace him at the Bailey Building and Loan Association. On Harry's graduation night in 1928, George, now 21 and preparing to travel before attending college, discusses his future with Mary Hatch, who has long had a crush on him. George's Uncle Billy tells George that his father has had a fatal stroke.
George gives up his summer travel plans to stay in Bedford Falls and sort out the firm's affairs, and a few months later, Mr. Henry F. Potter, a rapacious slumlord and a member of the Building and Loan Association board, tries to persuade the board of directors to dissolve the Building and Loan. George talks them into rejecting Potter's proposal, but they agree on condition that George run the Building and Loan.
Giving his college money to Harry, George delays his plans with the understanding that his younger brother, Harry, will take over upon graduation.
When Harry graduates from college, he brings home a wife, whose father has offered Harry an job. Although Harry vows to decline the offer out of respect for his brother, George cannot deny Harry such a fine opportunity and decides to keep running the Building and Loan.
George calls on Mary, who has recently returned home from college. After several arguments, they reveal their love for each other, and marry. As they depart for their honeymoon, there is a run on the bank that leaves the Building and Loan in danger of collapse. The couple quell the panic by using the $2,000 they set aside for their honeymoon to satisfy the depositors' needs. Mary enlists the help of George's two best friends, Bert, a policeman, and Ernie, a cab driver, to create a faux tropical setting for a substitute honeymoon.
The newlywed couple embrace while Bert and Ernie sing in the background.
George never manages to leave Bedford Falls, but does start Bailey Park, an affordable housing project. With his own interests compromised, Potter tries to hire him away, offering him a $20,000 salary, along with the promise of business trips to Europe, something that George always wanted. George turns Potter down after realizing that Potter intends to close down the Building and Loan and take full control of Bedford Falls. He and Mary have four children: Pete, Janie, Tommy and Zuzu.
On Christmas Eve morning, as the town prepares a hero's welcome for Harry, Uncle Billy is on his way to Potter's bank to deposit $8,000 of the Building and Loan's cash funds. He greets Potter (who has the newspaper reporting Harry's heroics) and taunts him by reading the headlines aloud. Potter angrily snatches the paper, but Billy allows the money to be snatched with it.
Potter opens the paper, notices the money and keeps it, knowing that loss of the money will result in bankruptcy for the Building and Loan and criminal charges for George. Uncle Billy can't remember what happened to the money, and with a bank examiner present, he and George frantically search the town, turning up nothing. George is devastated that he is apparently destined to face scandal and jail and takes his anger and frustrations out on his family.
A desperate George appeals to Potter for a loan. Potter sarcastically turns George down, and then swears out a warrant for his arrest for bank fraud. George, now completely depressed, gets drunk at the bar owned by his friend, Giuseppe Martini, where he silently prays for help.
After crashing his car, George staggers to a bridge, intending to commit suicide, feeling he is "worth more dead than alive" because of life insurance. Before he can leap, Clarence jumps in and pretends to be drowning. George rescues him and Clarence reveals himself to be George's guardian angel.
George does not believe him and bitterly wishes he had never been born. Inspired by this comment, Clarence shows George what the town would have been like without him. In this alternate scenario, Bedford Falls is instead named Pottersville, and is home to sleazy nightclubs, pawn shops, and immoral people.
Bailey Park has never been built, and remains an old cemetery. George notices that he can now hear in his left ear, that his lip is not bleeding, his clothes are dry and that he does not have Zuzu's flower petals, as he never existed in the alternate reality.
Mr. Gower is sent to prison for poisoning the child and is despised and homeless. Martini does not own the bar. Martini's bartender Nick owns the bar, and runs it in a reckless manner. George's friend Violet Bick is a taxi-dancer and is being arrested as George passes the location of the Building and Loan, now the location of the dance hall where Violet works.
Ernie is helplessly poor and his family has forsaken him. Uncle Billy has been in an insane asylum for many years since he lost his brother and the family business. Harry is dead as a result of George not being there to save him from drowning, and the servicemen he would have saved are also dead. George's mother is a bitter widow, and Mary is a shy, single spinster.
Clarence explains how George single-handedly prevented this. He, and he alone, kept Potter in check, preventing the town from descending into squalor and vice.
George runs back to the bridge and begs to be allowed to live again. His prayer is answered, and he runs home joyously, but the authorities are there to arrest him. Mary, Uncle Billy, and a flood of townspeople arrive with more than enough donations to save George and the Building and Loan.
Harry arrives to support his brother, and toasts George as "the richest man in town". In the pile of donated funds, George finds a copy of The Adventures of Tom Sawyer inscribed, "Dear George: Remember no man is a failure who has friends. P.S. Thanks for the wings! Love, Clarence." A bell on the Christmas tree rings, and his daughter, Zuzu, remembers aloud that it means an angel has just earned his wings. George realizes that he has had a wonderful life.