Walden,
The 4.2 V8's in the W124 cars(E420 and 400E) have fender clearances that will only allow for 225 section width rubber. You can fit up to 18" rims but I wouldn't recommend it. 225/50/16 or 225/45/17 will both help the handling greatly. As always the lower profile you go the more prone your setup is to bent rims from road irregularities. If your after handling performance, then the cash would be better spent on stickier tires. Bridgestone S-02's, Michelin MXXX3 Pilots, Pirelli P-Zero's are all good choices. Prefering a tad more tread-life I ran Firestone SZ50's. They outhandle the Goodyear F1's and get about the same treadlife with the same "AA" wet traction. 225/50/16 on 16x7.5" rims is what I ran on my 93 400E and it did very well. The rubber came to the very edge of the fender but didn't stick out and the handling went from dubious to 4-dr sports car. Eibach makes a lowering kit for about $350. If you get the kit you will also need sport shocks. Bilstein makes those for about the same money. The tires never rub with stock suspension, if you lowering alot you may get rubbing or other headaches. If your car has ASR, disabling it will help performance. I have been told there is a way to neuter the ASR on a W124 but I'll have to check specifics... Diff change is doable.(the stock 2.24 hurts performance) The 2.82 from the 500E will fit but it would run in the $2500 ballpark for the conversion.(not counting other small headaches like speedo re-calibration) European E420's had the 2.65 from the 6-cyl cars. Chips are easy and probably the best way to add power without getting into 4 or 5 figure tuner bills. You could do all these things to your E420 or put the cash toward a 500E/E500. That is what I am doing. I'm picking up a 92 500E and selling my 93 400E. Since the 400E didn't have ASR and the 500E does I will research a true ASR defeat solution and get back to you. Any other questions feel free to ask.

Hope this helps...Lee