A few thoughts ....
Ninjamom,
Actually, very few schools of Japanese sword arts sell equipment. It happens on accassion, but not very often. I highly agree with your advice about discussing what you buy with your sensei first. I've seen numerous people show up with poor quality iaito or ill fitting uniforms because they didn't discuss their purchases with their sensei first.
Sukerkin,
There are actually two distinct schools of thought on purchasing a first iaito. One agrees with you in that you should go for the best quality you can afford. This ensures that your iaito will give many years of good, worry-free service. The other school of thought says that you should go for an inexpensive beginner iaito of decent quality. This ensures that you have an iaito of sufficient quality to practice with regularly. However, you can save up money and, after having practiced a few years with the beginner iaito, you will have a better idea of what exactly you want out of an iaito and can purchase exactly that. I've known those that have gone in either direction, and it has worked out well.
BigNick,
I agree with your instructor's assessment. $500 is a fairly accurate round figure for beginner equipment in iaido. I want to second Socho's recommendation of Daimyo Outfitters. Good quality at decent prices. The fellow that makes them got into the business originally because he is a big guy and had a lot of trouble finding uniforms in his size. Take King's advice and don't be in a hurry to buy stuff though. Just practice with bokken for a while until you decide that you do want to do this long term. I have seen a number of people lay out a bunch of money and then decide they don't want to continue the struggle.
Good luck, and let us know how it goes!