iCloud & iCloud Photos · Online-only files and Optimize Mac Storage
What happens if I turn off Optimize Mac Storage for iCloud Drive?
Short answer: Your Mac downloads every file in iCloud Drive and keeps them locally, so it needs room for all of it. If you only need some folders offline, leave Optimize Mac Storage on and use Keep Downloaded for those folders instead.
Your Mac starts downloading every file in iCloud Drive and keeps them all locally. That needs enough free space for your whole iCloud Drive; if there isn't room, macOS may warn you or leave some files online-only.
Turn it off only if you need everything offline and have the space. Otherwise leave it on and use Keep Downloaded for the folders you need offline — see keeping a folder downloaded. Storage Studio can make files online-only again later if space runs short.