Best practice for affiliate links? Have I got it all wrong?

Hi.

I´d like your input on the subject "Affiliate links". More specifically; how do you work with them?

I for one, thought masking/cloaking, really anything at all - would be hassle-free as long as I bought Pretty Links Pro. I did. Figuring I struck two birds with one stone, I bought it to both utilize the group function for links, and masking the FUGLY affiliate links.

Creating affiliate links, regardless of cloaking, masking 301, and no follows - I´ve found that using a pretty link from my domain will show my domains URL, even when browsing the vendors site. This is definitely not what I want.

Key takeaway from quick research:

Cloaking: Considered bad. Blackhat SEO. Cheating SE-spiders. Begging for penalization.

301: Also bad when redirecting to outbound sites. Passes 90-99% of juice to landing-page. (Source: Seo-moz)

nofollow: Pointless.

I´m confused. What do I do to avoid Search Engines penalties and hatred? I´d really like to do this the right way, regardless of the amount of work that needs to be done.

Any input at all would be highly appreciated.