I have a 19" LCD, and I have it set up to use proportional scaling (in the NVidia driver) when I switch to 1280 x 960 mode. This leaves thin bars on the top and bottom of the screen, and it doesn't stretch the screen vertically at all.
Personaly, I think that games scale a lot better than the windows desktop, so I don't think that scaling the image will be so bad. With a 1600 x 1200 monitor, you still have the same option of not using all the screen if you don't want it scaled. The pixels are smaller, though, so the overall screen size will be less than if you use a 19" LCD.