I ran into a problem about 6 months ago – I didn't have enough room on my 16 GB iPhone 3G to put all my music on. This was partially thanks to upgrading most of my purchased tracks to iTunes Plus – they are twice the sound quality (at twice the size). I wasn't eligible for a low-cost upgrade from AT&T, so getting a 32 GB 3GS was out of my price range.
After removing some larger videos, I was still a couple of gigabytes short. So I used the "convert" feature of iTunes and converted all my higher-quality 256 kbps bit-rate songs to 128 kbps. It's not like you can really tell on the iPhone anyway. But this caused me some new problems.
For one, it meant having a duplicate set of about 1/3 of my music (although at half the size) eating up my disk. (The converted songs are in addition to, not replacements for, your original.) They're also in my iTunes library. Because of this, I had to come up with a Smart Playlist to make sure only the right songs got on the iPhone. That means I can't use any of my other playlists unless I want to substitute all the 256 kbps songs for their 128 kbps counterparts when playing on my Mac (and I don't).
So imagine my surprise and happiness at finding a new option in iTunes 9.1 – an option to automatically convert songs down to 128 kbps for your iPod! This option has been around for a while, but it was only offered up before if you were using an iPod Shuffle (maybe a Nano too?). Apple decided to open it up to all iPods, which is great. This meant I could use my normal playlists, save all that disk space (the songs are converted at sync time and a copy is not kept, like with the manual conversion), and not have duplicates cluttering up my library.
My happiness was short-lived. It seems that the converted songs don't keep the album artwork – you just get a generic music symbol on the iPhone. Now, on a Shuffle, that's a great idea – might as well strip those out, because you can't see them anyway. But it looks awful on my iPhone! I like perusing the album covers sometimes when looking for a song.
So I unchecked the option, recreated my Smart Playlist, and re-converted all those songs. I guess I'll have to wait for the 4G phone now (I was finally eligible for an upgrade for both my phones in March – and I figured I could wait a few months rather than buy a 3GS now).
So if you are temped to use the automatic conversion, be forewarned!