The lake hotel is on the lake with a beautiful view. However it is dated and shabby- personally would not consider this a luxury break. It is a very nice hotel though.
The Europe is extremely luxurious, as is the Aghadoe Heights, both are outside the town and you will need a car.
The Dunloe Castle is also a 5*, sometimes closes off season though.
The Great Southern AKA the Malton is lovely and is right in town, walking distance to everything.
On balance, as a near Killarney native, I'd go for the Great Southern or the Aghadoe Heights ( really nice spa) depending on whether you'd like to be in town or not.
Although to be honest with young children I'd probably be more likely to go self-catering but each to their own.