Depends what you want, you can encode the actual subtitles onto the video, this wastes bits and means that you are going to have the subtitles on the actual picture or encode at least part of the black border.
Or you can have a seperate subtitle stream, which means no wasting bits trying to encode text and you can have the subs on over the black border.
For seperate subs you can use the actual DVD subtitle stream or convert to a much smaller text stream using OCR software.
Subs streams can muxed into an AVI, OGM, MKV or kept as a seperate stream, which if it has the same name as the AV file will load automatically depending on the player/filters you are using.
I would suggest that you pop over to doom9 and read some of the subtitle guides over there or perhaps Chickenman has one here?
Also I would recommend that you change the way you do your audio, using BeSweet or HeadAC3e to downmix and encode.