Unless you really like having your music and pictures everywhere you go, I'd just stick with the 120GB hard drive and invest in an external one. I picked up a 1 TB Western Digital MyBook for $70 on sale about a year ago, still haven't filled it up (although I'm getting close). A 500GB internal drive would probably run you around $150+. I just keep music on my internal hard drive (160GB), around 40GB worth.
And yeah, Macbooks were built to last. Upgrading to 4GB of RAM will definitely give you more than enough power. Although if you're just using it for email and web stuff, you won't need anymore than the 2GB it comes with.