When you say the letters are cutting out too small because of the bit, what sort of cutting are you doing? Inside, outside, or on? Each is ever so slightly different and used for different things.
In your case, Inside cut would give you the outside dimensions minus the bit size. So it will be 1/8 inside every cut. If this is a rectangle, your box would end up being 1/4 inch smaller than the dimensions you used in your file. This is used to make pockets. Think the inside of the picture frame.
Outside cut mean it follows outside the line. This will give you the exact measurement that you set up in your file. This would be the outside of the picture frame. This is the one you want.
In your case on cuts split the difference. The bit will land right on the line. It’ll make your dimensions 1/16 smaller on every line. Same concept applies to inside cut also applies to on cuts. If you’re using an 1/8 bit and use an on cut for a rectangle, your end results going to be a rectangle that’s 1/8 smaller than your file dimensions. I use this mostly to make groves with angled bits.
I haven’t done what your trying to do but in my head you should be able to just take your letters, decrease the size ever so slightly (maybe a 1/32) so they fit in easier and use an outside cut. If it’s for a toddler, a bit of slop is probably not a bad thing.