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2. If I'm wrong about this being a loophole, there could be penalties that negate the benefits (why I'm posting here).

Yep - at a minimum, there would be 6% excess contribution penalty for each year you leave the excess contribution issue uncorrected.

I suspect that the IRS would say the the same pro-rated rules as IRAs applies, therefore you'd get no benefit.

The 6% penalty is likely to just be the start of your tax problems.

There is the little matter of a 401K withdrawal that you didn't declare as taxable income, plus the early withdrawal penalty (if before age 55 or 59). And if the amount you under-reported was be a large percent (which it probably is), you'll may get hit with a penalty for inaccurate and/or fraudulent return.
And they won't get around to send you the letter until 3 years after you filed, so you'll have 3 years of interest on the unpaid taxes & penalties. And you have 30 days to pay up.[*]

All-in-all, I think it's just not worth the risk.
[*] Lest you think I'm being rudely harsh, all this stuff was in a letter I once received from the IRS. Luckily, I was able to supply them with a copy of the form they lost, which showed that it was a 60-day rollover and not an IRA withdrawal plus an excess contribution.
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