A semiconductor device has an interposer mounted over a carrier. The interposer includes TSV formed either prior to or after mounting to the carrier. An opening is formed in the interposer. The interposer can have two-level stepped portions with a first vertical conduction path through a first stepped portion and second vertical conduction path through a second stepped portion. A first and second semiconductor die are mounted over the interposer. The second die is disposed within the opening of the interposer. A discrete semiconductor component can be mounted over the interposer. A conductive via can be formed through the second die or encapsulant. An encapsulant is deposited over the first and second die and interposer. A portion of the interposer can be removed to that the encapsulant forms around a side of the semiconductor device. An interconnect structure is formed over the interposer and second die.