Thanks Peter, that is extremely helpful. You are correct that I can only upgrade to 4MG. Based on your reply, it sounds like I am somewhat limited and my best alternative is to upgrade my memory and stay away from Windows 7 because I won't have adequate resources. So I should probably create a new XP vm (needs less memory?), transfer important files I want to keep, then delete the old XP vitual machine. And I shouldn't use the external disk for the vm location.
Is that what makes the most sense without replacing my Mac?