Media storage is on Mac (or PC). If you have a LOT of media you can control, that's usually organized on attached HDD storage. For example, I have a few TBs of home movies, a lot of ripped BD and DVD, etc. All of that is stored to a big HDD drive (and backed up to other drives just in case).
Mac then manages all of that for a very local stream to AppleTV in apps like Photos, Music and TV. You organize your media in those and then share up to all of it with AppleTV by making selections such as all or playlists or photo albums, etc.
In preferences of both Music and TV apps, you can uncheck an option that copies media to the internal drive when you add it to those apps...
That unchecked means it will index the media but leave it wherever it is. Indexed media is what AppleTV needs... but it doesn't care where the actual file is stored. When you have HUGE amounts of media, it can easily fill up a "puny" internal drive if you don't do this. So you leave it on the big storage you've allocated for this purpose but index it
like it's copied to the media folder.
AppleTV then has apps to present whatever is stored. My favorite for owned media is the Computers app. It has tabs for movies, TV shows, music, photos, etc. Think of that app running on AppleTV like "an iPod for your television."
There are many apps available to help "pretty" it all up too. For example, you can attach metadata and image posters to all of your media- even home movies- so there are descriptions, dates and some kind of image to represent it
before you view it. This can be quite helpful vs. having a list of 20 home videos called Thanksgiving and guessing at which one is the one you want to watch.
There are a variety of apps to help convert other media into a form for AppleTV. For example, you can convert anything on discs into a format for AppleTV and then store your discs only as worst-case backup option. While not as convenient as buying from iTunes, discs can cost less and let YOU decide the quality of the movie (compression) vs. letting strangers make all such decisions. Discs also offer true ownership vs. "lifetime lease" and a very last resort backup if ever needed.
There are services that can take ancient formats like home movie film and scan it into HD-quality video. If you want to delight family members, take a crack at that and old movies not seen for years will look beyond new again.
iCloud rentals/purchases that you do NOT download to the attached drive are generally accessed through the AppleTV+ app. My general advice is to always download all purchased media so you control your own copy vs. entirely leaning on complete strangers in the sky managing it for you. While others control the media, there is risk of losing access to the media. If it is downloaded to your own drive, even if the Studio strips the movie out of the store- which regularly happens with cloud versions- you can still watch the copy you control. I am no fan at all of "trusting the cloud," especially with massive storage options we can own and fully control ourselves priced so cheap.
As to how much storage you need in the AppleTV, if you will really use it only for streaming, you can opt for the $20 cheaper model. Local storage is mostly gobbled up by app sizes and whatever the current app needs in temporary storage to do whatever it is trying to do.
There
is a sizable App Library for AppleTV. If you go in thinking I want to only use it for some streaming apps but then you find some other apps you would like to use too, minimum base storage can be filled up. For example, while big games are often a kind of app that will eat up a lot of storage, they are not the only kind of apps that do so. There's also a few other benefits of the upgraded model that might justify paying the extra $20 too.
If it's more than only you in your household, will anyone else want to use it for other things? In other words, if home has more than 1 person, you should not choose based on your own expectations of use. Is there any gamer at home that might want to try a few on AppleTV? That will gobble up local storage.
Lastly (unless you have questions), work out a good backup option for your new Media drive(s). You don't want to go to the time & trouble of really maxing all of this out so that the experience is as good as it can be and then lose it all because the media storage drive conks. Be sure you have a backup option that regularly updates. I allocate a 20TB drive for my present and future home media needs, backed up locally to a Synology NAS AND another 20TB drive stored offsite (regularly rotating with another so that it is always quite up to date). In a fire/theft/flood scenario that takes out all storage at home, that one offsite backup is the ultimate recovery option.
IMO: AppleTV is a fantastic device. I can recall a time where the AV stack had a CD jukebox, a DVD player, VCR, etc. The home movie projector had to come out for those. The slide projector had to come out for those. Etc. Now this one, cheap little device can consolidate ALL of that classic hardware so that it is easily accessible and able to serve up as much media as anyone chooses to gather. Apple should "try harder" in helping people grasp the many benefits of an "iPod for your television" because this is one of their very best offerings (but probably least understood/most overlooked by even some fans).
