No matter whether you're upgrading an installation or doing a full install, you'll get best results out of installing to a clean hard disk. Yes, if you're upgrading, you will have to reinstall all your software; but in the long run you'll have fewer problems and find troubleshooting easier. If you don't have the time and energy to do that, however, press ahead like you would normally with an upgrade. I have run my system with both configurations and saw little difference. In some cases, though, I have had some legacy applications work under an upgrade and others that didn't, and vice versa with a clean install.
Your two options are FAT32 and NTFS. I run with FAT32 on my system disk but have my data disk partitioned into a FAT32 and a NTFS partition. I did a lot of research on both file systems, especially concerning performance, and had a second system I ran with a NTFS partition on the system disk. I saw little difference except when running NTFS with compression; and in that case, FAT32 was definitely faster and maybe a little faster than NTFS without it.
However, the version of FAT32 included with Windows XP will not format a drive partition larger than 32GB. I used my Windows 98SE boot disks to format and partition my drives and then installed XP on top of those, later using XP's Disk Management tools to create a NTFS partition I use for video capture. FAT32 has a 4GB file size limitation, and only 20 minutes of digital video will hit that limit.
Because I have a Visioneer Paperport mx scanner and some games that won't run well under XP, I have a dual boot system (Windows XP and Windows 98SE). Windows 98 systems cannot see disks formatted with NTFS. (This was why I formatted my data drive with a FAT32 file system, i.e., so it can be accessed no matter whether I am running XP or 98.) XP systems can see disk partitions formatted with either. (If you're accessing a Windows XP machine from a Windows 98 machine across a network, this is not a concern. The network handles everything for you.)
If you're going to share an external hard disk (Firewire or USB) between a Mac running OS X and a PC running Win98/XP, I recommend using FAT32.
Whether upgrading to Windows XP or any other operating system, the best thing you can do for yourself is to scout out drivers and problems with the OS ahead of time. Go to the manufacturer's website for each and every peripheral, video card, and sound card, etc., you have and download drivers for each before you upgrade. Put the drivers where you can access them during the upgrade process. You'll need them as the operating systems finds each one. To scout for problems, go to Google and do a search using keywords like ["peripheral name" Windows XP]. Then, look for helpful websites and follow that by clicking on the Groups tab and checking for newsgroup activity on that subject. XP's been out so long that nearly all manufacturers have drivers for it, though not every manufacturer chose to make drivers for every peripheral.
If that turns up nothing, check Microsoft's Knowledge Base for any mention of the peripheral. XP has some native support for a lot of peripherals, though usually it's more limited than that offered by the peripheral's manufacturer. If you can't find drivers or they don't work, you may be able to use XP's native support to get your card or device working.
It will also speed things up if you leave your PC hooked up to a phone or broadband line. If you're installing or re-installing XP and your version doesn't include Service Pack 1 (SP1), you'll need some way to download it and install it ASAP after the initial installation completes. Not to mention that sometime within 30 days after you install it, you'll need some kind of Internet hookup to deal with Microsoft's Draconian activation scheme. (You'll need it a lot sooner than that--like immediately--if you're doing a reinstall and the operating system doesn't like what it sees and thinks you're a pirate. That will mean a phone call to Microsoft to get a 50 digit activation code purposely given out to you so fast you have no time to write it down in case something happens and you need to reinstall again. They've got you by the balls, and they're not going to let you go.)
If you're upgrading from Windows 98, I'd keep that CD around not only because you're legally required to but in case Microsoft decides they're not going to let you run XP anymore without buying another license. That leaves you the option of dropping back to Windows 98 if for some reason XP won't run and Microsoft tells you it won't until you buy another license, and you decide that hell will freeze over (and take Redmond with it) before you'll do that.