A semiconductor wafer has a plurality of first semiconductor die. A second semiconductor die is mounted to the first semiconductor die. A shielding layer is formed between the first and second semiconductor die. An electrical interconnect, such as conductive pillar, bump, or bond wire, is formed between the first and second semiconductor die. A conductive TSV can be formed through the first and second semiconductor die. An encapsulant is deposited over the first and second semiconductor die and electrical interconnect. A heat sink is formed over the second semiconductor die. An interconnect structure, such as a bump, can be formed over the second semiconductor die. A portion of a backside of the first semiconductor die is removed. A protective layer is formed over exposed surfaces of the first semiconductor die. The protective layer covers the exposed backside and sidewalls of the first semiconductor die.