When iCloud is activated then the version on iCloud is the "master" and what is on your local device is essentially a reflection of the master, but it is physically present on your Mac, specifically in ~/Library. Time Machine dutifully backs up the contents of ~/Library.
I got that same warning a few days ago and took the "Later" option because I didn't want to fool o with it at the time. "Later'" has not recurred and I am assuming the whole thing was a glitch in the iCloud software. Because of the password issue I am guessing it was in the password server. If I were you I would taste the "Leter" option and forget about it.
