I'm sorry about your daughter. Those emergency room visits are always so scary and they do tend to put things into perspective.
Thanks for providing the additional layout details. That is a bit of a challenge, especially with just the one room upstairs in the attic! I have two very young kids as well and I can understand not wanting to be too far from them. We have a ranch house with the master bedroom at one end and the kids' rooms at the other end and it was hard for me to get used to them being so far, especially since they slept in our room for so long, but we did get used to it eventually, and we still use our baby monitors to keep tabs on them when they are in their rooms.
I do agree with another poster though that it might not be long before you would feel comfortable putting them upstairs and sleeping on the main floor, or vice versa. So my suggestion would be to try to make the layout work for now, while you save up money for the reno just in case (they might eventually want their own rooms when they're older). If you love where you live, the reno seems to make more sense, plus it is probably cheaper than upgrading to a bigger house and all the associated moving/selling costs. Even if you only save for part of the reno and use a HELOC for the rest, you would be coming out ahead of buying a bigger house (and getting a HELOC is similar to getting a bigger mortgage on a larger house anyway). I would not take money out of your retirement savings for this.
There are a lot of blogs devoted to small space living and I am sure there would be a way to fit a dining table and a couch/seating area in that room. The banquette idea proposed by pbkmaine is a good one, and it doesn't need to be built in. For example, you could use a settee on one side of the table instead of dining chairs and could easily move it for extra seating when guests are over. Or the dining table against the couch proposed above can work really well too. You could also replace some of the dining chairs with a bench that could be tucked under the table when not in use. It's hard to tell from the photos, but you might also be able to switch the orientation of the table to find wall space for a small sofa.