My step-dad, who was ill with pancreatic cancer for 18 months, passed away in April, my DS (almost 4) had become very close to Poppa and saw him get very sick so I didn't need to explain that part but explaining he passed away while I was grieving was hard, but he saw that it was ok at the same time. My grandfather passed when I was around his age and I was not allowed at the funeral "because its not appropriate for children" and I have struggled with that my entire life, so I took my son too (it was closed casket). If he felt uncomfortable at all I would have walked out, but I think it's important for children to see how people grieve and the different stages and that its all ok. We told him poppa had died and we couldn't see him any more (no sugar coating) and that he could choose a star in the sky for him and he could talk to him any time he wants to (that part is more a family tradition). He has accepted it and still talks about his poppa and says he's a star flying in the sky near the moon and that he loves him lots. He talks about happy and sad times, so I think in his own way he's understood grieving can be sad but happy at the same time.
That's what we did and it worked for us, but that's not to say it will for others.