Scientists in Canada found a clear trend after tracking the progress of more than six million adults for 11 years.
People living within 50m of heavy traffic had a 7% higher risk of developing dementia compared with those whose homes were more than 300m away.
The increased risk fell to 4% for those living 50-100m from a busy road and to 2% between 101-200m. Beyond 200m there was no evidence of a link.
For people living in a major city, who never moved from a home within 50m of a busy road, the dementia risk was increased by as much as 12%.
The findings are backed up by recent studies suggesting that long-term exposure to two common traffic pollutants - nitrogen dioxide and sooty particles generated by diesel engines - may contribute to brain shrinkage and mental impairment.
Lead scientist Dr Hong Chen, from Public Health Ontario, said: "With our widespread exposure to traffic and the greater tendency for people to live in cities these days, this has serious public health implications.
"Increasing population growth and urbanisation has placed many people close to heavy traffic, and with widespread exposure to traffic and growing rates of dementia, even a modest effect from near-road exposure could pose a large public health burden."
The study, published in The Lancet medical journal, monitored the progress of every adult aged between 20 and 85 living in Ontario from 2001 to 2012.
In total, around 6.6 million people took part in the research.
Postcodes were used to determine how close people lived to a road, and rates of dementia, Parkinson's disease and multiple sclerosis (MS) obtained from medical records.
During the study period, the scientists identified 243,611 cases of dementia, 31,577 of Parkinson's and 9,247 of MS.
No association was seen between proximity to busy roads and incidence of Parkinson's or multiple sclerosis.
British experts described the findings as "important" and "provocative", but stressed that they highlighted associations and did not demonstrate a causal link between exposure to traffic and dementia.
Dr David Reynolds, chief scientific officer at Alzheimer's Research UK, said: "Conditions like dementia have multiple risk factors including age and genetics, and other social factors relating to where people live in cities could also be playing a part here.
"This study has identified major roads and air pollutants from traffic as possible risk factors for dementia, a finding which will need further investigation before any firm conclusions can be drawn about the relative risks of air pollutants for dementia versus other risks such as smoking, lack of exercise or being overweight."
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