Hello, deejay166.
Thank you for visiting Apple Support Communities.
This message means that you will need to free up space on your device before you can update. The first thing that I would recommend would be to import all of your photos and videos taken with the iPhone. Once this is done it will give you the option to remove these and at that point attempt to update.
iOS: Import personal photos and videos from iOS devices to your computer
http://support.apple.com/kb/ht4083
You can also temporarily remove synced music, videos and apps to free up space for the update.
iOS: Syncing your data with iTunes
http://support.apple.com/kb/ht1386
Cheers,
Jason H.