These would be my suggestions -
1) 650cc engine plus gearbox/differential.
The only modifications necessary are to the rear engine mount, the halfshafts and the starter.
The standard 126 rear engine mount studs are too short and need to be exchanged for the longer ones off your 500 engine.
The halfshafts will be too long and will need to be replaced with shorter 25mm shafts from the later model 500s. These are available new.
The 126 starter has a solenoid rather than the cable mechanism, so you'll need to wire up a starter button - very easy.
The 126 gearbox has synchros on 2nd, 3rd and 4th gears and also better ratios for cruising. A five speed conversion would be interesting, though I've not done it.
You'll also need to 'panelbeat' the metal cabin airducting so it clears the front (electrical end) of the starter motor.
2) Engine work.
The standard 650 is powerful enough though can be improved with a little effort.
Remove the head and install slightly bigger valves - The 500s had 32mm inlet valves and the 650s had 33mm valves. Exhaust valves were 28mm on each (I think). I've installed 34mm inlet and 29mm exhaust. Easy to do and worth the effort.
Install a 'sport' camshaft. Various height/duration cams are available.
The little Weber 24IMB should be replaced by a slightly bigger IMB (28mm) - these are also available. The IMBs are OK but do tend to flood/vapour lock in warm weather making the cars difficlut to hot start. The 30DIC is supposed to be a better carby, though I have no experience with them. Some people go as far as fitting a later model Panda twin port head and a twin throat carby, but I've heard that this doesn't give much of a performance boost unless you do a lot more to modify the engine. Also, the standard tinware will not fit if you use the Panda head. After a lot of hunting around, I fitted a Dell'Orto FZD to my single port head.
A sports exhaust system makes the little beast sound better and the twin pipes look good.
Electronic ignitions are great. Like you, I've installed a 123ignition distributor and have not regretted it.
3) Suspension.
You can lower the car but it is not really necessary. Decent shockies are worth it, just don't go too hard as these little cars are already fairly bouncy.
4) Brakes.
Standard 500 brakes are OK, though you can upgrade to the 126 hubs with little difficulty. This then gives you a more modern wheel stud pattern (4x98) which means that you have a greater variety of wheels to choose from and also can fit more modern tyre patterns. I have front disc brakes, 126 rear drums and 126 wheels fitted with 145/70R12 tyres. One day I'll get myself a nice set of 12" mags. You can go up to 13" wheels and fatter tyres, but I've heard that there are problems with rubbing, so you end up flaring the guards.
That's really about it.
These little cars are great fun just as they are, but can be modernised a bit so that you can at least keep up with the traffic.
Let us know how you get on,
Chris