Hi Alonzo,
Glad to hear that someone else is as crazy as I am.
I put the data you posted into the program and you are absolutely right. It says that 1/8" bit is too big for that gear/pinion. In fact you could cut the gear and just ignore the warning and all that would happen is that the gullet would be under cut and a slightly weaker tooth would result. (The contact surface would have the proper shape.) If the undercut is too much then the gear won't be strong enough, and a tooth will break off.
I am cutting pinions of the size you specify and I am using a 1/16" bit or 0.062".
These are available at the site given below. They have a huge selection and the address I'm giving here is where I get my 1/16" bits and I get 10 at a time. I run them at 4 - 8 inches per minute and take cuts of about 0.08" per pass. They have a pretty good life and over time (3 or 4 gears) they will start to scorch, but that doesn't produce a bad surface for me and I continue to use them until I manage to do something stupid and break them.
http://drillcity.stores.yahoo.net/10fracpac.html
I notice that you put in a press angle of 14.5º in the involute program - do you have a reason for this? The default is 20º.