I have XM on my 496 and a third gen (most recent) iPod Nano. I use both of them in my airplane.
In terms of in-flight entertainment, they each have their merits. The iPod is very nice when doing acro, etc. because you can sort of have your own "soundtrack". Also, with XM the music will cut out when inverted.
As mentioned already, XM is so much more than music. I'm a news nut, so I really enjoy having the news channels such as CNN, BBC, etc. If you like talk radio, there's America Right (conservative talk) and Air America (liberal talk). Also, I like XM for the baseball coverage...they have every game.
The only downside to XM on the 396/496 is the interface. Honestly, it isn't very well done. I'm seriously considering installing a separate XM box during my annual next month, mainly so my passenger (read: my wife) can control the audio.
If you go with an iPod, I would recommend the touch or the nano because they have solid state flash memory...no need to worry about babying the sensitive hard drive. I have a piece of Velcro on the back of my Nano and just stick it to the instrument panel. Quick, easy and the nano is still just as functional and portable.
If you have an iPod, you will probably have to go into the "Volume Limit" setting and max it out. This setting allows parents to limit the max volume on their kids' ipods, but for our intercoms we probably want the maximum output available.