If you're going to varnish over the vinyl, why bother putting it on a
plastic sheet? Why not just stick the vinyl letters to the wood and
varnish the whole thing?


Probably true. My solution is to put lots of coats of varnish over
the graphics, sanding lightly between coats. Gradually the surface
begins to level out to the point where you can varnish and sand
without worrying about what is underneath.