well my current limiting resistors are set up to let the LEDs in the encoder draw 30mA which is there max current, and 10mA below the atMegas328's current limit. Im guessing between the higher current pulses and the 6 inch wires to the breadboad Im getting current spikes coupled in to the encoder inputs. I just added .1uf caps right next to the LEDs and everything was smoothed out. 
Its really hard to figure out if problems are hardware or software related. The weird thing is the encoder originally bounced really bad so added a 100hz RC filter to it to take care of the bouncing, I would have thought this would block out any captive noise?