Custom Taxonomy Navigation, with current menu items for children?

I believe the behavior you’re hoping for is not part of WordPress core. The last time I needed this, I adapted a couple functions out of the Post Type Archive Link plugin used for improved post type highlighting. To use it, just add the menu items the normal way and put these functions in a plugin or theme.

// Get menus to play nicely with the submenu script
// blissfully borrowed from Post Type Archive Links plugin, thanks @stephenharris, @F J Kaiser, @ryancurban
function mrw_tax_archive_current( $items ) {
    foreach ( $items as $item ) {
        if ( 'taxonomy' !== $item->type )
            continue;

        global $post;

        if( !$post )
            continue;

        $taxonomy = $item->object;
        $taxonomy_term = $item->object_id;
        if (
            ! is_tax( $taxonomy, $taxonomy_term )
            AND ! has_term( $taxonomy_term, $taxonomy, $post->ID )
        )
            continue;

        // Make item current
        $item->current = true;
        $item->classes[] = 'current-menu-item';

        // Loop through ancestors and give them 'parent' or 'ancestor' class
        $active_anc_item_ids = mrw_get_item_ancestors( $item );
        foreach ( $items as $key => $parent_item ) {
            $classes = (array) $parent_item->classes;

            // If menu item is the parent
            if ( $parent_item->db_id == $item->menu_item_parent ) {
                $classes[] = 'current-menu-parent';
                $items[ $key ]->current_item_parent = true;
            }

            // If menu item is an ancestor
            if ( in_array( intval( $parent_item->db_id ), $active_anc_item_ids ) ) {
                $classes[] = 'current-menu-ancestor';
                $items[ $key ]->current_item_ancestor = true;
            }

            $items[ $key ]->classes = array_unique( $classes );
        }
    }

    return $items;
}
add_filter('wp_nav_menu_objects','mrw_tax_archive_current');

function mrw_get_item_ancestors( $item ) {
    $anc_id = absint( $item->db_id );

    $active_anc_item_ids = array();
    while (
        $anc_id = get_post_meta( $anc_id, '_menu_item_menu_item_parent', true )
        AND ! in_array( $anc_id, $active_anc_item_ids )
    )
        $active_anc_item_ids[] = $anc_id;

    return $active_anc_item_ids;
}