How do I finish my piece now? Do I sand again and re-apply water-based Poly?
What are the silver/gray marks and how do I get rid of them?
As the silvery areas only appeared after using the steel wool, and seem to disappear when wetted, a fresh coat of finish may be all that's required to remove them1. But see last point.
Used 000 steel wool to get rid of lifts/defects
Steel wool shouldn't be used between coats of waterbased poly, as you say in the Question this is due to the chance of rust from specs of steel left behind on/in the surface.
Now that you have done so you have two main options:
- take the chance of recoating with the existing finish after carefully cleaning the surface, you can sand lightly as part of this but regardless you must very thoroughly dust it;
- switch to using an oil-based varnish.
Obviously the colour of the finish will be different in the second case.
Note: for future reference steel wool is not ideal for this purpose anyway. Fine abrasive papers work better for de-nibbing dried finish — steel wool tends to round over defects rather than cutting through them like sanding does. Some people prefer not to sand and use 'synthetic steel wool' (e.g. Scotch-Brite) instead which cuts more like abrasive paper than steel wool.
From the Comments:
The time between stain to coat was like 24 hours later.
This may not have been long enough, although I realise it follows the product guidelines exactly. For the same kind of stain other manufacturers recommend a wait of 72 hours between stain and application of waterbased finishes.
This gives us a hint that Rust-Oleum's instructions may be a little underestimated..... the fact that they are also a manufacturer that grossly understates the time for their Premium Wood Conditioner to dry to achieve ideal results2 makes this even more likely I think!
It's possible this has had a contributory effect to the silvery areas you're seeing. Or may be the underlying cause, pun intended — the finish is poorly adhering to areas of stain that haven't dried sufficiently. If this is the case a fresh coat of finish will not remove the problem entirely and I'm afraid your only recourse is to strip off the finish and start again.
1 All finishes will get a somewhat grey or silvery appearance when abraded simply because the surface is now covered in fine scratches which scatter the light. This is the same basic effect as between a gloss varnish and a matt varnish, or normal glass and reduced-glare glass used in a picture frame.
2 See How Wood Conditioners are Giving Washcoats a Bad Name on Popular Woodworking.