I guess the advantage of having your XML reside there in your project (or solution even) is that you can maintain it in VS with nice formatting and even intelli-sense, but then using something like XML Spy or whatever can give you that too.
To refer to it in a class you'll need to ensure you have access to it, and that it resides in a reliable place.
In the past I've used post build events to move the latest copy of the file to where I need it. As Arnshea writes here is another answer, "to the output directory". You can use the "Copy to Output directory" property on the XML file itself to achieve this. Then your classes can use the XML file, knowing it will reside in a reliable place.
You'll need to make sure it's accessible though especially if you're writing back to it. Make sure it doesn't end up "Read Only" - as Source Control system could do to you. Storing these files in a folder under Program Files could also be problematic especially on Vista, where user privileges are (should be) restricted.