When DHs mother died when DD1 was 1yr old she was too young to understand, obviously! but over time as she has got older we have talked about Nanna and i sort of add a bit more every few months to meet her understanding level. We tell her that although we can think about Nanna and always love her we cant see or touch her any more. she got sick and died. it was only in the last few weeks that we talked about 'spirits' as she heard it somewhere else. im not religious.
it might be an idea to tell them seperatly as they will probably react very differently , and like you said you eldest will have questions that might confuse the 3yr old.

sorry that you have to deal with this, so sad for the kids to loose someone like this!!