The saga continues! Thanks again guys for all your continued assistance. So I disassembled again and took a few more pictures based on the responses and tested a few more things to see if I can help to narrow my issue down. Again any opinions will be tested to the best of my ability.
Here is the gear sleeve and dog with spring. The dog looks very flush to the gears as well as in the next picture I have the washer on top with a gap.

Here is the fiber washer, however I am using the Carbontex included with the set I purchased from Scotts

To try to isolate the dog as being a cause of the issue I tested it dragged down without the assemble around it and it was smooth no hang-ups.

When reassembled with the free spool lever in "Off" there's is still some reeling movement, causing me to believe it isn't fully disengaging, but no grinding noise. In "On" it is rough to move and grinds.
Alto you mean just the spring where it may stick through the barrel, not the barrel part that connects to the lever correct? I will look at that.
This reel has been sitting in my dads rafters for as long as I can remember, may have even been my grandfathers at some point, and I don't think its been touched since the late 80's maybe 90's. I can't comment as to if any work was done to it and my dad can't remember its been so long, but I can fairly certainly suggest that nothing that could have been done would be an "upgrade".