yes, ü requires punycode encoding. The xn-- prefix indicates that.
And because there are way too many ways to confuse people with similar looking characters, the domains can be typed in and converted appropriately, but some webbrowsers ensure that you notice if something is off with www.bаnkofamerica. com (www.xn--bnkofamerica-x9j. com)
There are a bunch of ideas, like giving different unicode codepoints groups different background colors. That way, а and a show up differently colored.
It's more a UX problem than a technical one, so simple "why not X?" technical proposals tend to be incomplete.
I believe it's also a regulatory problem. Plankalkül on a German site makes perfect sense, because that is a German word. But then there would be millions of ways to form domains that serve no other purpose than misleading the users. So registrars would need to make sure that all letters belong to the same script and make sense i the language(s) native to the domain.
But then this is the internet and greedy and incompetent registrars are a fact, so I am not sure this will ever happen.
As for the UX, maybe displaying a little flag or similar emoji indicating what script it is. And showing a big warning or completely blocking the site of the user has not accepted the script in question. That is for the whole domain, mixing scripts in a single domain should be massively limited and requires other indicators in foreground or background. Also a problem for the color blind.
And because there are way too many ways to confuse people with similar looking characters, the domains can be typed in and converted appropriately, but some webbrowsers ensure that you notice if something is off with www.bаnkofamerica. com (www.xn--bnkofamerica-x9j. com)