Jim Daly, the president and CEO of Focus on the Family, has posted an excellent piece on his blog, Daly Focus, that gives some great advice for talking with young children about death.
His first bit of advice is to prepare the child for what's coming. Death is as inescapable a reality as life, and it is good for children to understand in a general way that all living things eventually die. Daly suggests using object lessons from nature–the death of a pet, the fading of a flower arrangement–to prepare a child to process and understand death.
Next, Daly recommends telling the truth about dying. "Grandma went on vacation" does not help a child understand death. On the other hand, it is important to help a child understand the difference between a common cold and cancer. Daly suggests “Grandma has a unique, different illness that’s very serious called cancer. You can’t catch cancer like you can catch a cold.”
Daly's third point is to prepare the child for the grieving process. Help the child understand that when a loved one dies, those left behind may experience a range of emotions from sadness to anger to confusion, and that those emotion may give rise to expressions that trouble the child. It is helpful for the child to know he might see Daddy cry, and that is normal.
Finally, Daly suggests that teaching children about death gives us a chance to tell them about our faith. Depending on what that faith is, a child (of any age) might find comfort in hearing about Heaven and eternal life.