You should definitely not keep flying the tattered flag (as you obviously know). My dad is a Vietnam War veteran and makes a point of keeping flags updated around my hometown. He sends letters to businesses/homeowners asking them to get a new flag and/or stop flying tattered and faded flags. He's even bought new flags for some of them.
Anyway, the proper way to dispose of a flag is by burning it. I wouldn't make a big deal out of it. I think having a "retirement party" like you suggested is going a bit overboard, but that's just me. I would just make it clear to your family members that you're disposing of the flag in a particular fashion and that it does indeed matter to you.
Kudos to you for taking this stuff seriously.