Both tags and categories are built-in features of WordPress (and most blogging platforms) to help organize your content. While both are generally working toward the same aim, the way each of them works and how you'd want to apply them are a bit different.
We'll start broad with categories.
Categories cover broad sections of your site content
Assigning categories to your blog posts helps sort everything out at a broad level. Here's an example. If you're a home improvement business that handles both kitchens and bathrooms, you might start with creating post categories for each of those. This way any tips, news, etc. you write about bathrooms can be easily sorted out of the kitchen stuff.
You can create links to your post categories, which will display a chronological list of only the posts with that category assigned to them. In this way you can essentially create multiple blogs on the site if the topics are pretty distinct from each other. Categories can also be a subtle cue to search engines about the subject matter of posts. The gain is minimal, but many things in SEO are indeed that way, and you succeed by the additive effect of getting dozens of little touches right.
Tags allow you to focus in on specific subtopics
It's best to control the number of post categories you create, otherwise it can get confusing. When you want to get more specific about the subject matter within a given category, tags are what you use.
We can use this post as an example. We've filed it under the 'Web Tips' category, but also added tags like organizing content, tags, categories, and content topics. You can go deeper with tags, but it's generally best to restrict a post to 10 tags or less. If you need more tags than that you're either being too specific or too broad.
You can create links to tags the same way you would categories, and it will display a chronological list of all posts with that tag.
Readers performing searches on your site, if your site has a search box on it, can better find content with tags that relate to those searches. It also helps you internally if you're doing post searches to bring up relevant matches.
Search engines also take a mild cue from the tags assigned to your posts to determine what they are about. It's not as significant as it used to be as the algorithms have changed, but a lot of SEOs still swear by them for ranking purposes as well.
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