Comment 8 for bug 482496

This bug is actually trying to avoid broken messages. If someone sets default charset to iso-8859-1, it would be unwise to enforce it ultimately and completely disallow e.g. latin-2 characters completely.

So yes, it should work as you describe - if reply_in_default_charset is set, Thunderbird should start off with your default charset (and not with the charset from original message). But if the text doesn't fit it should silently switch to UTF-8 like in all other cases without asking the users questions they don't understand and without giving them opportunity to break emails by clicking "Send anyway".