I have the funds to improve my equipment and I was wondering between 5D mk2 or 7D + better lens. Also what lens would be more appropriate?
What sort of budget are you working with? The 85mm f/1.2L II on a 5DII is an excellent combination for portraits. But the 85mm f/1.8 on a 5DII is nearly as good (I often stop down from f/1.2 on my 85L for a little more DoF), and will produce better results than a 7D + 50mm f/1.2L, as an example.
The 135mm f/2L is excellent for head shots (an 85mm f/1.8 will give you similar framing on an APS-C body like yours).
Realistically, though, what makes a portrait is light (the same could be said about any photograph, I suppose...). IMO, the best place to spend your money is on lighting, and a 430EX II alone isn't going to cut it. Look at modifiers, especially softboxes (for a Speedlite, I like the Ezybox Hotshoe). You'll need more than one, and light stands, too. Better yet, monolights will allow more flexibility (opinions vary, but Paul C. Buff offers economical options of good quality). Look into radio triggers. Backgrounds and a support stand for them.
Don't get me wrong - a FF camera and fast prime do great indoors, too. Here's an example:
EOS 5D Mark II, EF 85mm f/1.2L
II USM @ 1/60 s, f/1.8, ISO 400
This was shot with a single 430EX II bounced off a white ceiling, and at f/1.8 on FF the fabric right behind the subject's head is blurred out (as is her left eye - see what I mean about thin DoF?).
My point is that I think you'll produce better results with your current body (though I'd recommend getting the 50mm f/1.4 and/or the 85mm f/1.8 ) and control
over light - both with the lights and the practice to use them. For the cost of the 85mm f/1.2L II, you can get a decent set of monolights, stands, softboxes, radio triggers, and backgrounds.
Want a practical, real-world example? Go into a portrait studio, and you'll often see them using APS-C bodies and kit lenses (e.g. Canon 50D or Nikon D90 with an 18-135mm f/3.5-5.6 lens), along with a standard 3-monolight setup (key light, hair/accent light, and background light) and pull-down backdrops. Yes, you can spend thousands on a FF body and ultrafast primes - and they're great for portraits. But the reason the 50/1.2L, 85/1.2L II and 135/2 are used for portraits is that they deliver a thin DoF which allows you to blur out a busy background and focus attention on the subject. That's necessary outdoors - but in a studio setting, you
have control of the background.